H & R Block Inc (HRB) 2010 Q4 法說會逐字稿

Good day and welcome to today's web conference.

During today's event for those dialed into the audio bridge all lines have been muted to prevent background noise.

This event is being recorded.

There will be a question-and-answer session after the formal comments.

(Operator Instructions)

At this time we would like to welcome everyone to today's web event titled Fiscal 2010 Earning's Conference Call.

At this time it is my pleasure to turn the floor over to Mr.

Derek Drysdale.

Mr.

Drysdale, you have the floor.

Thank you for joining us today to discuss our fiscal 2010 results.

Presenting on the call are Russ Smyth, President and CEO; and Jeff Brown, our Controller and Interim Chief Financial Officer.

Other members of our senior management team will be available during the Q&A session.

I would like to remind everyone that today's remarks will include forward-looking statements as defined under the Securities Exchange Act of 1934.

Such statements are those relating to matters that are not historical facts and such statements are based on current information and management's expectations as of this date and are not guarantees of future performance.

Forward-looking statements involve certain risks, uncertainties and assumptions that are difficult to predict and as a result actual outcomes and results could materially differ.

Please see the risk factors included in our most recent periodic reports and other filings with the Securities and Exchange Commission.

H&R Block undertakes no obligation to publicly update such risk factors or forward-looking statements.

Following our prepared remarks we will open up the call to Q&A to give as many participants as possible an opportunity to ask a question, we ask that you limit your query to one initial question and then one related follow-up if needed.

With that I'll now turn the call over to Russ.

Thanks, Derek, and good afternoon, everyone.

Earlier today we announced our fiscal 2010 results.

We generated consolidated net income of $1.43 per share this year, which is a slight decline of 1.3% from last year.

Despite the IRS suffering its largest decline in total filings in nearly 40 years, and while these IRS results reflect the impact of an overall unemployment level of nearly 10%, for many in our core client base unemployment was in the 15% to 30% range.

Given our overall performance this year, our financial position and liquidity base remain very strong, which enables us to make the right strategic choices for growing our business and returning value to shareholders.

Here's a quick recap of our fiscal 2010 results.

We prepared 20.1 million US tax returns this season down about 4% from a year ago.

We did a better job of retaining our existing clients.

In fact our retention to the brand increased 130 basis points to 71.6%, but our marketing and pricing initiatives did not generate adequate new client growth to compensate for the loss in clients due to record levels of unemployment.

We lost 65 basis points of share in the assisted market and 100 basis points in the digital on-line category.

At McGladrey, we successfully resolved the dispute with McGladrey & Pullen and created a new operating agreement that resolves the nagging issues of the past and positions the partnership for growth.

However, there was a one-time drop in income as a result of this dispute, and it adversely affected RSM's ability to participate in proposals for new client engagements and we incurred more than $6 million of related legal expense.

Despite a difficult operating environment, we generated strong free cash flow of nearly $500 million, we returned substantially all of our earnings to shareholders in the form of share repurchase and dividends.

In the past two quarters alone we repurchased nearly 13 million shares, ending the year with $1.4 billion of equity and just $1.1 billion of total debt.

These repurchases reflect our confidence in the future of our business.

So with that overview, our goal today is to talk about the areas in which we saw progress and in those in which we need to improve.

Now, I'll also share some of our plans to address both the opportunities and the challenges that we expect to see in the tax industry next year.

But the headlines are this, we have got three key challenges for fiscal 2011.

First, we've got to reduce the early season client loss in our retail business.

Second, we need to significantly change our approach to be more competitive in digital.

And, third, we need to ensure that the McGladrey business is back on track growing top line revenues, partner income and bottom line profits.

I'll talk more specifically about the actions we plan to take for each of these later on in the call.

But first I'd like to start by sharing our analysis of the tax season 2010.

We saw very clear and pronounced contrast between the first and second half of this tax season.

Our results were directionally consistent with the trends in IRS filings which were down significantly in the first half, but recovered in the second half of tax season.

More than 90% of our client loss this year was among lower, adjusted gross income, first half filers, particularly those who file with 1040A form and those who take settlement products.

As you can see on this slide, unemployment rates within this client segment are up two to three times the national average.

Many were not required or chose not to file while others went to an independent tax preparer.

Some may have chosen a digital alternative but based on our performance improvement in the second half we believe many of these loss returns went unfiled.

We estimate that the total industry shift from assisted to DIY was about 75 basis points or approximately 1 million returns this year.

The shift was significantly lower than our original projection of 100 to 125 basis points, and occurred predominantly in the first half of the season.

Frankly, we believe that the challenging economic conditions would lead to a larger shift.

Our recent data indicates that even during hard times and with changing demographic trends, the assisted tax category remains both resilient and relevant.

In fact, the assisted category currently represents 61% of total IRS filings, compared to 39% for do-it-yourself.

These are the exact same percentages that they were back in 2002.

Another key factor for our early season performance was our inability to take advantage of the RAL disruption that occurred.

We expected to see an increase in new clients since we had RAL funding and many competitors did not.

There was a lot of confusion in the settlement product space and our marketing or word of mouth were not able to dispel that confusion.

So one of our top priorities for the 2011 tax season is to ensure that our overall value proposition and messaging to first peak clients will be both clear and more effective.

Our second half results reflect improvement in both our performance and the overall industry as indicated by our same-office returns being up 1%, and our assisted market share holding essentially flat.

Second half clients tend to have higher incomes and they have been less impacted by the economic conditions.

We also believe our overall value proposition and our marketing messages resonated better with second-half clients.

So those are the quick headlines from this past year.

So now lets turn to some of the initiatives that we outlined at December's investor conference just prior to tax season.

The first set of these initiatives were designed to improve the quality of our client experience and we saw meaningful improvement against these initiatives this year which we believe will lead to better retention next year.

Clients in our tax offices were served much better and when clients called us with a question or issue, they were quickly addressed or resolved.

Here is why we are confident in these claims.

First, we moved approximately 800,000 clients to our higher-performing tax professionals which helped improve perceptions of tax expertise and should lead to better retention rates.

Second, clients who said they will refer were up 2 points to 55%, and those who said they were confident with their results were up 8 points to 87%.

At our call center, our handle rates were up by more than 23 points to 98%.

And our first-call resolution scores were up by more than 10 points.

And, finally, we reduced our walk-out rate by 5 percentage points or about 575,000 clients.

These improvements increased our client retention levels after years of steady declines and we'll continue to improve the quality of our client experience which will increase satisfaction, our value proposition, and further increase retention.

In our retail marketing initiatives, our top priority was growing new clients through increased brand consideration and trial.

Although improving consideration is a long-term goal, we did not change perceptions quickly enough to drive new clients in the first half.

We made some key adjustments to our messaging and mid-season with more direct calls to action.

And as a result we gained nearly 2 points of growth in new, non-settlement product clients.

We'll build on this second-half progress and our marketing focus in 2011 will be squarely focussed on driving traffic into our retail offices.

Another key opportunity in retail is settlement product marketing.

This was a big miss for us this last year, but it promises to be an even bigger opportunity for the upcoming season.

With the benefit of 20-20 hindsight, we were too late to get our message out last year.

Our message wasn't clear enough to cut through the confusion in the marketplace and we didn't direct enough of our marketing resources to take advantage of this particular opportunity.

With more time to prepare for this season, we expect significant improvement in our performance in this critical piece of our early season business in fiscal year '11.

Turning to our pricing initiatives.

We said we would moderate increases to help improve our overall value proposition in conjunction with the service enhancements previously mentioned.

And we did exactly that.

Our long-term objective remains to increase revenues through a healthy balance of client growth and targeted pricing actions.

Specifically in fiscal year 2010, we held list prices flat throughout the year and let complexity flow through.

We offset some of these increases with targeted pricing actions to accelerate trial and improve retention.

Net of these actions our average net -- our aggregate net average charge increased by about 1%.

Given the market conditions, we believe that showing restraint on pricing was the right thing to do for this past year.

We've learned a lot about what pricing can and cannot do in terms of impacting our short and long-term business results.

Through the various price tests we ran this season we validated that retail clients remain relatively price inelastic and that price reductions will not result in immediate and significant client growth.

We also know from some of our longer term testing that over time pricing is an effective tool to prevent client attrition and is an important factor in client's perception of our overall value proposition.

We also learned that relative to the overall industry, our average pricing is near the median.

However, it's important to keep in mind that one size does not fit all, and averages can be very misleading.

And we evaluate price relative to our product and service offerings by specific client segments.

That's the reason we targeted 1040EZ clients this year with an attractive $39 federal return offer.

While our pricing actions did not help us grow our 1040EZ clients as we expected, it did help stabilize our market share after two consecutive years of share loss with this base form.

This group of clients were typically younger in age, are a critical part of our long-term growth pipeline, so it is important we capture them early, give them a great experience and retain them over the long run.

As we view pricing in light of our targeted client segments, there are opportunities to adjust pricing either up or down, in conjunction with our service improvements, to deliver both client and shareholder value.

However, as I said earlier, each year's pricing decisions will stand on their own and they will be evaluated relative to the competitive landscape, and done in conjunction with our strategic business objectives.

By improving our service levels this year and showing restraint on pricing, we believe we have actually improved our pricing power for the long term.

So we view our price adjustments in fiscal 2010 as a multi-year investment, which will have a compounding impact over time.

Within the overall digital category the on-line space continue to grow while software and free file alliance categories continue to shrink.

In the on line category, which we believe is the key battleground in digital, our returns grew by 4%, but we lost 100 basis points of market share.

Meanwhile our software share declined by 170 basis points due to our decision to exit two unprofitable retail channels that accounted for about 250,000 returns.

In the FFA category our returns increased by nearly 3% and we estimate that we gained about 240 basis points of share.

At the investor conference we said we would commit to digital by making significant product improvements to get to parity with the competition.

Over the past year we redesigned and enhanced our product to improve the client experience and added the ability to import W-2 data and financial institution records.

As a result of these changes, independent reviews such as those from the New York Times, PC Magazine and Consumer Reports just to name a few, reported that our improvements approached parity with the competitors.

We also made solid progress in our digital marketing efforts but did not convert as we should have.

Awareness and consideration of our digital offerings were both up 4% each in part due to our Click, Call or Come Over campaign.

These efforts resulted in a 25% increase in website visits, but only a 4% increase in clients.

So clearly we have an opportunity to improve our conversion rate of visitors to clients.

Next season in digital we'll continue to build on the things that worked and improve on those that didn't.

So the keys to our digital performance next year are, first, we will overhaul our website to improve our conversion rates.

Second, we'll use the free message much more aggressively to drive new clients as we know this is a critical entry point into the digital on-line category.

Third, we'll significantly reduce our digital operating costs so we'll become even more profitable as we achieve greater scale.

And, finally, we'll invest in top leadership talent to drive these business results.

Looking beyond next year, we will leverage other strategic opportunities to help us grow our clients in new ways.

For example, our recent partnership with Yodlee gives us a chance to become the tax service provider for more than 25 million on-line banking clients currently being served by Yodlee's platform.

Our last set of initiatives involve franchising and optimizing our office footprint, and we delivered on our plan to franchise up to 300 Company operated locations this last year.

We still have an opportunity to improve our performance in some offices by putting them in the hands of local entrepreneurs.

But in addition, we believe there is substantial opportunity over time to attract independent tax preparers to H&R Block as franchisees, particularly those who may be looking for access to settlement products as well as strong training and infrastructure support.

We also reduced our office footprint by more than 1,000 Wal-Marts and approximately 400 other office locations, we saved $35 million in operating costs.

Our actual retention rates for these closures was slightly above our target.

However, these closures did result in a loss of approximately 84,000 clients net of those retention efforts.

We'll continue to monitor office level performance to ensure we have right-sized our office footprint.

Now I'll turn the call over to Jeff to discuss our operating results and financial position.

Thanks, Russ.

In our tax services segment pretax income was $867 million, down more than 6% from the prior year and segment revenues fell 5% to $3 billion.

These results were driven primarily by declines in tax returns prepared.

Total expenses dropped by nearly $100 million or 4.4%.

Lower expenses were primarily the result of variable field compensation, reductions in our network footprint, and incremental gains on the sale of tax offices.

We expect to continue our efforts to sell certain tax offices that we believe are better operated by franchisees, but at reduced levels in the coming year.

Despite our top-line challenges during the year, pretax margins were still solid at 29%.

Current year margins exceeded 2008 levels by over 200 basis points due both to gains on tax office sales, as well as focussed cost control during that two-year period.

In business services, McGladrey's revenues declined about 4% to $860 million.

The current economic climate has continued to pressure billable rates and hours within the industry and companies had fewer discretionary dollars to spend on consulting.

Pretax income for the segment fell nearly 39% to $59 million.

Profitability was negatively impacted by one-time expenses associated with the previously resolved dispute with McGladrey & Pullen and other costs of litigation.

Results also reflect a $15 million goodwill impairment charge at our capital market's business unit.

Excluding these charges, pretax income for the segment would have been $88 million and our pretax margin would have been 10.3%, essentially flat with prior year.

Our revenue shortfall was partially mitigated by cost reduction efforts throughout the year.

Those efforts included head count reductions to reflect lower demand, as well as other actions to reduce costs without impacting client service levels.

In corporate, our pretax loss of $142 million improved by nearly 23%.

Lower losses were primarily due to reduced loss provisions on mortgage loans, reductions in insurance costs, and gains on residual interest assets.

These results include one-time favorable items of approximately $19 million, which are not expected to repeat in 2011.

Our mortgage loan portfolio is static and continues to decline.

Net mortgage loans held for investment declined by approximately $150 million during the year to $595 million at year-end, substantially lower than the nearly $1.4 billion of loans held on our balance sheet just three years ago.

Net loans at year end included only $350 million previously originated by option one.

We saw delinquency and loss severity rates level off during the year and loan loss provisions declined from $64 million last year, to $48 million in the current year.

Our allowance for loan loss was $94 million or 13.7% of outstanding principal at year-end.

Losses relating to loan repurchase obligations of our former mortgage business also remain low.

It has been over two years since we completed the sale of this business and subsequently set up reserves totaling $243 million.

During that period we have incurred actual losses of $55 million, and ended the current fiscal year with $188 million of remaining reserves.

We have not experienced any significant change in recent repurchase activity and although future claims cannot be predicted with certainty, we believe that time is our ally and trends over the last two years support the adequacy of our current reserves.

Our net loss in discontinued operations was less than $10 million compared to a loss of $27 million in 2009.

Declining primarily as a result of losses from the disposition of our financial advisory business last year.

Turning now to our financial position, we ended the year with a solid balance sheet and strong liquidity.

In March we successfully obtained a $1.7 billion committed line of credit through July 2013.

In addition, we ended the year with $1.8 billion of cash and total debt of $1.1 billion was flat to the prior year.

Our equity was essentially flat at $1.4 billion, as substantially all of our current-year earnings were returned to shareholders through share repurchase and dividends.

The Company repurchased and retired nearly 13 million shares during the fiscal year at a cost of $250 million, including repurchases of 6 million shares in the fourth quarter at a cost of $100 million or about $17 per share.

Fiscal 2010 fully diluted shares outstanding were 333 million.

Because share repurchases were mainly completed in the latter part of the year, they had a minimal impact on our average shares outstanding.

We currently have more than $1.6 billion of share repurchase authorization remaining.

Receivables declined to $518 million from a seasonal high of $2.6 billion in our fiscal third quarter reflecting the normal pattern of collections relating to our Emerald Advance line of credit product and our participation in RALs.

Our effective tax rate for continuing operations was 37.6% compared to 38.9% in the prior year.

This decline was due to tax planning strategies which resulted in a $9 million reduction in deferred tax valuation allowances and non-taxable benefits on Company-owned life insurance.

For the coming year we expect our full-year continuing operations tax rate to approximate 39%.

Depreciation and amortization was $127 million for the year, and our normal ongoing operating capital expenditures were $91 million.

We expect no material change to these levels in fiscal 2011.

And with that I'll turn the call back to Russ.

Thanks, Jeff.

Before I close I'd like to make just a few remarks about the external environment.

No one really knows when the economy will recover or at what rate.

However, we do know that for IRS filings to grow it will require either an increase in employment levels or some type of government stimulus program executed through the tax code similar with what we saw with ESA in 2008.

There's also continued uncertainty in the RAL marketplace.

Chase has exited the RAL business and there is a chance that others may follow.

However, we think it is likely that we'll have some competition for this product.

We are pleased that H&R Block is in the very enviable position of having a partner who's committed to funding RALs.

In addition, an IRS and treasury working group are reviewing settlement product usage within the tax preparation industry.

We have been told to expect a report on its findings sometime in July.

This group has been reviewing a number of things including the IRS practice of providing the debt indicator used in the RAL approval process.

At Block we're commited to offering best in class settlement products to meet the significant client demand this tax season and we are well positioned to adjust as necessary in response to any changes brought about by this working group.

You saw in our release that today we are not providing detailed earnings guidance.

We are committed to growing both revenues and earnings and we're confident in our ability to execute our plan.

However, the uncertainties of employment levels, financial settlement products, tax code changes and the fact that substantially all of our revenues and earnings are generated in the fourth quarter caused us not to predict results at this time.

As things play out in the coming months we will continue to be transparent with all of our stakeholders, as we have been with our disclosures in reporting the last few years.

But for now here is a recap of directional insights for fiscal 2011.

First, we will return -- we will continue to return substantially all of our earnings in shareholders via share repurchase and dividends.

Second, we had a number of one-time charges and gains in fiscal 2010, which with the exception of gains on sales of tax offices, largely offset each other.

Please note that for your convenience we have included an appendix slide which recaps these one-time items.

As we mentioned earlier our fiscal 2010 results included gains of $49 million on the sale of tax offices.

Although we will continue to look for opportunities to transfer certain tax offices to qualified franchisees, we expect future activity will be at lower levels than this past year.

Next, we expect to incur a one-time pretax charge for severance related costs in connection with last month's reorganization.

We expect the amount of the charge to be less than previously announced.

About $19 million, most of which will occur in the first quarter.

We also expect no material change in our normal ongoing capital expenditures or depreciation and amortization amounts.

For next year we expect our effective tax rate to approximate 39% and, lastly, we have had no significant change in loan repurchase activity and we believe current reserves are adequate.

And our static mortgage loan portfolio that is held for investment continues to wind down and appears to have stabilized.

Now it is important to remember that we're starting year two of a three-year growth plan.

As I mentioned before, the tax market environment is in unchartered waters.

The economy, unemployment, the regulatory environment, are all in a state of transition, and as a result so are customer needs.

Although we can't predict the future, we are prepared to leverage our considerable strengths to create competitive advantages out of challenging market conditions.

As you've heard today, we believe we've started on the right path by building on what we know works and quickly adjusting what doesn't.

Our retail tax group is our biggest income contributor and continues to be our bread and butter and it is not going away any time soon.

We're taking the necessary steps to enhance our products and experiences to be best in class, and we've taken a big step in re-engineering our cost structure to allow us to become the best value provider in the industry.

We believe we can reduce the loss in early season clients by being more effective at targeting key client segments from both an operational and a marketing perspective with a particular emphasis on settlement product clients.

As for our digital efforts, they continue to be an important element of our long-term growth strategy, even though today digital's profit contribution is significantly less than retail.

As I mentioned earlier, in order to improve, we're making significant changes that include an overhaul of our website to improve our conversion rates.

Increased emphasis on using the free message to drive new client growth.

Significantly improving our operating cost structure within digital to further enhance profitability as we gain more scale.

And investing in top class leadership talent to help drive our business results.

At McGladrey, our new operating agreement and partnership with McGladrey & Pullen has been significantly strengthened.

C.E.

Andrews and his new leadership team are in place, they are focussed on growing the business and are incentiveized to grow quickly.

They are exploring both organic and strategic opportunities to grow revenues, partner income and profitability.

And we expect McGladrey to get back to both top line and especially bottom line growth in fiscal year '11.

Within all of our businesses, we're -- attacking our cost structure will continue to be an important part of our ongoing objectives.

We've already taken significant steps to be a much leaner and more cost effective organization, and we'll continue to ensure that cost discipline is ingrained in every part of our business.

We're getting more client-focussed.

We're improving the client experience, and we're gaining better insights into what motivates our customers' behavior.

And we will continue to get better and better at this every year.

Finally, our people are one of our strongest assets.

We've created a structure that gets us closer to the customer while also creating a culture of responsibility and accountability for results.

Going forward, we're excited about the opportunities and we remain focussed on improving our business in spite of external market factors and doing it in a manner that achieves sustainable growth in fiscal year '11, fiscal year '12, fiscal year '13 and beyond.

So with that we are now ready to take your questions.

(Operator Instructions) So, operator, looks like we're having some sort of technical difficulties.

We see that there are people in queue.

Yes, sir, and your first question does come from the line of Scott Schneeberger.

Hey, Scott.

Thank you.

Hey, Russ, good afternoon, everyone.

I guess, first question, the $140 million to $150 million of cost savings, the question here is how much of that are you going to take and reinvest in the growth of the business, and how much are you going to use that to help show us some margin expansion and let fall to the bottom line?

And just the way you think about that, and you discuss that with the board?

Thanks, Russ.

Well, Scott, you know, it is a combination--it's a combination of the two, and, you know, we think it will be both.

But essentially, you know, I think a lot of that is going to help fund our profitability improvement over the next several years.

And, you know, our target for was the $140 to 150 million you mentioned, just to remind everyone, was through a fiscal year '12 and we haven't said how much is going to be in fiscal year '11 or in '12, so it is over a two-year period.

It is a combination of two.

Investments for growth.

You know, we made some good investments last year and we think that we can continue at those kind of cost rates and a lot of our action steps as we anticipate going into next year we don't believe are going to require as significant investment levels in '11 or '12, as what we invested in fiscal year '10.

Okay.

Thanks.

You did mention earlier that you do expect to drive, you know, on an outlook revenue growth, and any PS growth, and so thus I would assume some margin expansion.

I guess from the follow-up, if I could ask, what is the thought process on return of cash to shareholders?

You certainly have a lot sitting on the balance sheet now, and I'm just curious how aggressive you may be with that going forward?

Thanks.

Yes, Scott, on returning cash to shareholders, the, you know, the limiting factor on what we can return has nothing to do with our cash balance.

The biggest limiting factor for us are the net equity covenants in our commercial line of credit agreements.

As I think most of you know, we've just renegotiated that agreement in I believe it was February of this year, under extremely favorable terms, but one of the covenants that remains from before was a minimum net equity covenant of $650 million.

And so essentially that's what prevents us from taking more of our cash on the balance sheet and returning it to shareholders either in the forms of more share buy-backs or dividends, and that's why this year we returned, you know, substantially all of our earnings to shareholders.

And as we said in kind of our outlook going forward, we would expect to do the same in fiscal year '11, as well.

But that's -- that's the limiting factor.

It is not cash availability.

Okay.

Thanks.

And I'll go back into queue but just a follow-up to that, though, with you guys continuing to strengthen your balance sheet, I would imagine just directionally you feel pretty comfortable that you can do a good bit of share repurchase because even in your down season you reflect well on that covenant?

Well, as you saw, we were pretty active in repurchasing shares in the last quarter.

And so, you know, if you like the stock price at $17, it's not a leap of faith to assume that we like it better where it's at today.

In terms of share repurchases.

Not in terms of that we're happy with the overall stock price.

Understood.

Thanks.

I'll hop back into queue .

Your next question comes from the line of Michael Millman.

Hey Michael.

Thank you.

Hi, can you give us a little more insight and maybe quantification of your thinking regarding marketing expense, when you this year expect to be more aggressive and again quantify compared to last year and maybe give us some idea what you expect total expenditures to be and I guess, also, in the past you found marketing often resonates well on surveys, but not on the bottom line.

You know, Mike, in terms of the overall marketing dollars, we've never disclosed our total spend in marketing.

However, having said that, when we talk about our marketing being more aggressive, you should not assume that that means that we're necessarily going to spend more.

My comments about it being more aggressive are really about the messaging within marketing.

And I believe what you saw us do in the second half of this tax season, is a lot more direct and bolder and prouder of all of the great things that we have to brag about, with the products and services at H&R Block, and less what I would, you know, brand, generic and feel-good stuff, and had a stronger call to action.

And those market's messages seemed to resonate better.

So a big part of when I say more aggressive, it is in the type of tone and call to action that you can expect us to have with all of our messaging for next year.

You know, in addition to that, as we look at our marketing spend, we plan to kind of reallocate our resources in different ways for fiscal year '11, and into different priorities than when we put them into this last tax season.

So clearly we plan to invest more marketing resources, direct more marketing resources, into supporting our growth of clients looking for great settlement products in fiscal year '11.

It is one of our absolute strengths.

We have the best in class products.

We have the best and fairest pricing in the industry.

We have the best disclosures around it.

And as we pointed out several times we have a great supply and availability of the RAL funding.

And so we just need to leverage all of those assets much better and marketing will play an important part of more effectively communicating that and I believe that that will then resonate better on the bottom line than some of our marketing has resonated in the recent past.

Historically you always told us that you had a concern with doing that heavy early season because of the fact on making it look like a RAL shop in the late season.

How do you get around that now?

Well, you know, Mike, you know, we lost 900,000 clients this last tax season.

As we've said, over 90% of them were first peak, low-income, AGI filers.

You know, looking for settlement products.

We cannot allow that to happen.

Period.

We're doing much better in the second half so we're strong there.

You know, we need to prop up where we are weak and get much more aggressive and much more competitive.

It may be a quick -- can you actually tell us actually what the revenue in profits for digital were this year compared with last year?

As you know, we don't separately disclose the digital revenue or product results.

Those are included within the tax services segment and always have been.

Can you give us an order of magnitude?

Significantly -- as I said, significantly smaller than retail revenues and profitability.

Can you tell us whether they were up or down?

It was up.

Thank you.

Your next question comes from the line of Sloan Bolan.

Thank you.

Good afternoon.

Russ, can you maybe talk -- little bit about the marketing -- but to what degree do you guys look at pricing as a tool that you have for client retention in 2011, certainly it seems like you believe that the value of your product relative to your competitors is there, but, you know, to maybe send a shock in the top line or improve profitability, to what degree would you use pricing as a tool?

Well Sloan, as we said in the piece, we look at the pricing by key client segments.

And I think, you know, with certain client segments, as we evaluated our pricing relative to the competition, you know, we think we have got room to adjust upwards.

And, you know, we will do that where we think it makes good business sense.

We also learned this year that, you know, pricing reductions, you know, have proven to be just as inelastic with our clients even in these tougher economic times, as what the company has seen historically in the many previous years when they were increasing prices.

So we know it is not a short-term client mover, but we do know that it has an impact, you know, over a three, four and five-year period.

And, so I think pricing is one action that we review by client segment in conjunction with a number of different actions, from a service perspective, from a marketing perspective, from a product perspective, and you know it is one tool in the toolkit but it is not the only thing that moves our top line business and it is not the only thing that moves our bottom line business, and we're just going to approach it from that perspective.

It's a part of the toolkit and it's got to be done in balance and in conjunction with a number of other things.

Okay.

I guess a related question that you have a sense for the I guess price elasticity or sensitivity within your groupings of clients and whether it be by income or how you think about them?

So, for example, the (inaudible) stuff on the lower end of the income section.

Yes I mean, I'm not going to give -- we do know specifically by client segment price sensitivity.

Okay?

I don't want to give away all of that good competitive information on a public call, but generally I will say, and this probably won't come as too much of a shock, that the lower-income level folks tend to be more price-sensitive around tax prep pricing.

Than higher income levels.

Okay.

All right.

Thank you.

Your next question comes from the line of Vance Edelson.

I'm in for Vance.

Russ, I have two questions, one of your goals is more for next year is new client growth.

Can you just give us, you know, a sense of what your plans are or maybe more details of how you plan to grow in that area?

Well, the one specific area, Vance, you know, that we said we've got to focus on, is the settlement product clientele.

It was our biggest missed opportunity last year, but because of the continued disruption in the RAL marketplace, we believe that that there is an even greater opportunity for us in fiscal year '11 and because of the strength of our settlement products and the availability of our settlement products it is also one of our distinct competitive advantages.

So that is clearly an area that we have to leverage better and should contribute very significantly to our new client growth initiatives in fiscal year '11.

You know, we also think in terms of client growth that, you know, a learning from this last year was and I think I mentioned in the call script -- in the second half of this tax season, we grew our non-settlement product clients and we grew our same-office returns in the second half.

So clearly the message is about our tax expertise, moving more clients to our best educated and trained and highest-performing tax pros.

Those are messages that seem to be resonating in the market plans we think that will help us grow our new clients in the second half of next tax season, as well.

And then adding on to that, I think all of the work we have done on improving service and call center and just client handling issues, and we saw retention bump this year, we think that's going to continue to build momentum, and so increasing retention every year for our business, also forces us to have less new client growth in order to get, you know, to get back to, or exceed, our overall client levels from the previous year.

So I think it's really primarily a combination of those three on the retail front.

In terms of our digital clients, as we mentioned, you know, the different marketing initiatives drove a lot of traffic to our website.

A 25% increase.

Our problem was our website is just far too clunky and tough to get through, and it takes too many clicks from a client you know to enter the website to get to actually become a user of the product.

And so we've really got to redesign the website, make it much easier for the clients to get from the entry point on the website to entry point on the product.

And as we improve that conversion rate, that should drive a -- increase a significant number of clients on the digital side as well or push to really more openly and aggressively use the free message in the digital space.

Yes, we've clearly seen within our own results, as well as across the industry, more and more clients are entering digital on-line in a free option.

And then, you know, are converting over to different pay choices.

But they're entering through free, and so we've just got to get more aggressive in pushing that free message in the digital on-line space.

So those are the two big areas that I think we'll have an impact on client growth within the digital segment.

Great, just follow up on the digital segment, I think you have a product in there called Best of Both which basically somebody does it on-line and then gets help from a tax (inaudible).

I'm just wondering, can you give us a little color on what traction you saw on that specific product?

Yes, Best of Both is a product that was in pilot mode this last year.

It got off to a slow start frankly because we had some technical difficulties with some of the changes that we had made to the programs in the software.

Once those were resolved, I believe that it grew pretty significantly from February through the end of season, and was up probably around -- about 25% to 35%, I think, more like 35% in the second half.

But it is still small base of numbers.

While we think offering clients choices around services within the digital realm is an interesting idea, at this point, you know, we haven't been able to find the right way to prove that there is great client demand for it.

But we'll continue to kind of tweak it and, you know, and try to improve on it.

But at this point none of us should count on that being a significant driver of growth in our digital business for fiscal year '11.

Okay.

Great.

And then just lastly could you talk little bit more about refranchising, you know, just probably longer term, what goals you have and how you see that being out over the next year?

Yes, as we mentioned we did just under 300 sales of company offices to franchisees in fiscal year '10.

You know, we think we picked the lowest hanging fruit off of those lists.

However, we still believe there are opportunities in geographic areas that are pretty remote from where we can easily support them with company personnel and/or in ethnic communities in urban cities where a franchisee of that ethnicity we believe would do a significantly better job of running the office than company employees would.

So we still have those types of opportunities and they're pretty -- they're still pretty meaningful but it won't happen at the same rate as it did this last year.

You know, how many will do will be based on getting the right quality franchise candidate in those geographies, or in those ethnic communities.

But maybe, you know, somewhere between 25% to 50% of the same level as we did last year into fiscal year '11.

Great.

Thanks very much.

Your next question comes from the line of Bill (Kirkachi).

Good evening.

Russ, a follow-up on your comments earlier about the minimum $650 million net worth covenant.

So it looks like given where you are right now, that kind of incorporates some cushion for the potential or for the unprofitable off-season.

And, so is this kind of a level that we can look to as kind of like a baseline, you know, year after year at least for the time being so that to the extent, you know, you drive earnings growth that kind of flows into routine earnings and you exceed this $1.4 billion mark which we've now seen the last couple of years that would be available for return to shareholders via repurchases and dividends?

Bill, I'll let Jeff brown our interim CFO take that one.

This is Jeff.

There is probably two key things to think about in that regard.

We have $650 million covenant that acts as a gatekeeper I guess, if you will, as to how much share repurchase we can do.

We have to look to, as you alluded to, our off-season losses, and therefore typically the third quarter is kind of our low point of equity.

So as we think about share repurchase early in the year we always have to anticipate where we will land at the end of that third quarter.

And I think really, you know the second key thought which Russ mentioned in the prepared remarks, is that as has been historically our intent really is to return to shareholders earnings that we make during any given fiscal year.

And so you know whether it's in the form of dividends or share repurchase, we'll look to some mix of those two key components to return value to shareholders every year.

And Bill, this is Russ, again, beyond that, you know, if we were to do something else that would have a positive impact on net equity, that is not earnings related, that would change the dynamic going forward.

And in addition, as we look at kind of that low point that Jeff described in quarter three, obviously we want to keep some buffer for unknowns and we don't want to get too perilously close and risk being in violation of those covenants, particularly given the very favorable terms that we got through that commercial line of credit.

Right.

And can you give an example of what would be something that would positively impact that equity balance?

Would that be the sale of some asset or anything that would fit that description?

An increase in goodwill or other intangible asset would be something that would, I believe, would increase our net equity.

Okay.

I'll follow up with you guys on that one off-line, but another question is kind of along the lines of the digital growth that you guys have been talking about, just from a big-picture perspective, if we just kind of dissect that, where that is going to kind of be coming from, do you foresee more of it kind of coming from stealing share from the likes of Intuit or is there still enough a fairly large numbers of people using pencil and paper today that you could convert over to your digital solution?

You know, the population of pencil and paper users is diminishing pretty quickly, and so there is, you know, at the current run rates there is maybe another three or so years left before there will be very, very few pencil and paper users and I suspect there is some of those folks that are going to keep using pencil and paper until they're not filing returns anymore at all.

So I think, you know, more of the growth of the category is going to have to come from us stealing share, from other competitors, Intuit and others, as well as, you know, we mentioned that we have seen some migration from assist to do digital overall the last two years.

This year it was 75 basis points or about a million returns, and last year I think it was 50 basis points so probably 700,000 returns last year that migrate into the digital category and actually, you know, puts some tailwind into their growth beyond just stealing from pencil and paper.

Okay.

And on the regulatory changes requiring tax preparer certification, can you just talk about, you know, from the standpoint of the benefit that you stand to gain from that, is that something that just kind of comes, or is there a way you could position yourself so that you can make sure that you're one of the main beneficiaries of that change, if you could just share some of your thoughts on that.

Yes, I think for any tax preparers to be able to benefit from the change, I think, you know, we need to have a better sense of two things from the IRS, that they haven't yet clarified completely for us.

The first is from an enforcement standpoint, what are they going to do and what resources will they have available to ensure that once people are certified and registered, that they are strictly enforcing, you know, the tax regs for those individuals.

Absent enforcement, you know, frankly these changes will not have the impact that I know the IRS wants and intends them to have.

And so we believe that they will determine how to properly enforce this, but they haven't shared with any of us exactly how they'll do that, and until we know that, it will be hard to determine how much benefit we can get.

The second potential benefit for us is really how the IRS will allow those preparers that are certified and registered to be able to essentially market this feature.

So will they allow people to be able to say that they are an IRS certified preparer or IRS approved preparer and to the extent they allow Block and others who have passed and registered, to have some kind of additional, you know, certification name that we can apply, I think that's a feature that would help us all differentiate from ourselves -- ourselves from others in the category, and that would benefit from us.

So I think enforcement and kind of ability to have some type of IRS certification tag are the two big things that would create benefit for Block or others who are certified and registered.

But, Russ, on the enforcement comment wouldn't they need to put their certification number on the return and, therefore, you would know whether the return was being prepared by somebody who is certified or not?

And if it's not, then you just don't accept it and you can enforce it in just as simple a way as that.

I don't know, I guess, can you help me understand that.

Well I guess so.

Let's use pay stub filing as an example.

So, right now there is a regulation that prohibits filing with an end of year paystub as opposed to a W-2.

There are a number of returns that are filed with paystubs, and, you know, it is very difficult to track that and enforce it when you've got 120,000 individual tax preparers, even if they're registered.

So while they will have the tracking mechanism, Bill, you know, if they don't use the tracking mechanism to identify those who are not complying with their regulations and then following up with them, just having them being registered, doesn't really accomplish very much.

Got it.

Thank you for taking all of my questions and just one final one, if I may, this is one I've been getting asked a lot and I didn't hear it in the prepared remarks, but if I missed it I apologize, but just the value of the loans that are being backed by your rep in warranty reserve, is that something you might be able to disclose with us, and once again that's it and thanks for taking all my questions.

You know, so, Bill, it is not a number we ordinarily disclose.

You know, option one originated loans that are still outstanding, we have several billions of dollars of principal balance that's still outstanding that would correspond to that $188 million reserve we referenced in our prepared remarks.

Okay.

Thank you very much.

Your next question comes from the line of (Fish Kneu LaCrage).

Hey, guys, thanks for taking my calls.

Forgive me but I'm still a little confused as to how the digital product is going to interface with your office product, your office service?

Can you give me a little color as to how that is going to flow through 2011 and maybe beyond that?

I'm sorry, could you repeat the piece about how our digital product is going to--

You guys are an office preparer, your service is brick and mortar.

However, it looks like some of the customers for that service are moving over to digital.

I'm just trying to get a sense as to how you plan on dealing with that, or what is your plan for digital moving along with the office?

The first thing I'll say is that, you know, we've got to run these like two separate businesses.

Right.

We've got the retail office business and we've got to grow that business and drive that business aggressively.

On the other hand there is this interesting little emerging category called digital on-line software that has been growing significantly the past 10 years, mostly at the expense of pencil and paper.

But I think for us to be effective from a long-term standpoint it is important for us to also be very competitive in the digital on-line space.

And I'll give you a specific reason why.

Because when we see that clients are using our digital products, as their life gets more complicated and they own a house and have kids and they then need more help preparing their taxes and want to see a tax specialist, when they are using our digital product and make that switch, they use our retail tax offices at two to three times the rates that people that don't use our digital products come into our tax offices.

So essentially digital looks like it could be a very attractive feeder channel for younger clientele with simpler returns to do their returns when they're young, but as their life gets more complicated, but they've learned to like our product and trust our brand, when they go to switch to a tax specialist, they are far more likely to pick one at H&R Block.

And so I think for that reason it's very important to be in the digital business, you know, as well.

Because it will be a feeder channel for retail.

And I also think we can very profitable in the digital business as a stand alone entity.

So I think those are the two reasons I think it is important to play in the digital business.

We think there is a business to be had there.

We think it can be very profitable.

And, two, we think ultimately it is a great with way to expose young people to our brand and give us a better chance to serve them in a retail office later in their life.

Moving on to my next question then, looking at the RAL product itself, how do you see that moving forward?

Looks like Washington is poised or may do something here in the next year or two in terms of either cutting back the fees you can charge for those or limiting them to a degree.

How do you view those moving forward along with you at this services?

I know we have Kate Fulton who is our Senior VP in charge of government relations and public policy on the line, Kate do you want to talk about what has been happening in Washington on this front.

Sure, as you may know when the IRS announced a return for proposals they announced at the same time a creation of a working group that is based at the IRS but includes bank regulators and treasury.

We understand (inaudible).

So Kate, I think we've lost you.

So, let me try to pick up.

Sorry.

Are you back?

I'm here.

Okay.

Keep going.

And that as I stated in the initial announcement in January, they intend to do look at debt indicator.

We under that the debt indicator it is how it's furnished on the table.

We don't know yet exactly what they might do in terms of withholding or positioning of the debt indicator.

They're also looking at a variety of fees charged in the industry and we do expect that they'll release it for changes to be made in time for this tax season.

So we do believe that their intention is to make a decision so that changes can be implement for this tax season.

Yes, I know here in Kansas City we had a hard time hearing Kate I'm not sure if everyone else had the same--

Is that better?

Yes, much.

Okay.

All right.

I'll just reiterate quickly that we do expect that this working group that's housed at the IRS, and includes members of the financial regulatory community and treasury will issue a report in July; that will likely impact this tax season.

And that we understand they're looking at the debt indicator.

We're not exactly sure what they may recommend in terms of the way the debt indicator is provided or whether they'll condition providing the debt indicator, they're also looking at a variety of fees and that they intend to have the report released in time for the recommendations or the direction to be implemented in time for this tax season.

Got you.

That makes sense.

Sorry you couldn't hear me before.

That's Okay.

Thank you.

Um-hum.

You know, in terms of what impact that could possibly have, you know, on Block or the industry, you know, from a debt indicator standpoint, Block is one of the few firms that offers a RAL that doesn't rely on the debt indicator.

It is called an instant RAL, you know, so we believe that if they were to make the decision to pull the debt indicator that we would be in well positioned, because we've already got an operational product available, you know, that product is at a higher price to the clients because it carries more credit risk because we don't have the debt indicator provided so that would be an unfortunate consequence from a client standpoint but we would have product availability, we believe, even if the IRS were to not make the debt indicator available to tax preparers.

Got you.

Appreciate it.

Thank you.

Your next question comes from the line of Michael Chapman.

Hey, Russ, couple quick questions on the special items.

I'm assuming you just want to check that $38 million, that's pretax?

That is pretax.

And the gain on sale, was that in corporate or was that actually in tax services?

It is in tax services.

Okay.

And then the previously you guys had said that you would like to buy back $2 billion over four years, about $500 million in share backs.

Is the new discussion of returning all earnings to shareholders, is that now the -- now the description of that and we should disregard the $500 million or is that roughly $500 million a year still in your minds the number you're shooting for?

So I'm going to have to apologize because I'm not 100% certain about what you're referring to with regard to the $500 million P I think what I would say is--

You guys said $2 billion over four years.

Yes.

Okay.

So we still have $1.6 billion remaining on that authorization, that is through 2013, you know, it provides us more authorization than what we'll actually achieve in share repurchase through that time period.

But I think, you know, what I would say is much like our historical practice has been, our intent will be to either return as much value to shareholders as we can and the earnings that we make in any given year will return to shareholders through some combination of share repurchase or dividend.

And, Michael, I'm not sure if you were at our investor conference prior to last tax season, we did say that while we were still operating under that $2 billion share repurchase authorization, that it might take us an additional year or so beyond what we had originally thought at the time that that was announced.

So, you know, I do want to reiterate that again here, because that's part of the answer to your question, I believe.

And then just two quick followups, what was the ending share count and then when does your share buy-back black out period around earnings end?

And so -- hey, Michael, rather than have the financial folks here trying to search through a lot of data for that, can we have Derek follow up with you?

That would be great.

Thank you.

Thank you.

Your next question comes from the line of Scott Schneeberger.

Welcome back, Scott.

Hey, guys, thanks for taking the follow-up.

I actually have a few, I'll ask them all up front if you want to -- if you want to jot them down.

First one is your view of dividends versus repurchases and dividend increases, perhaps versus repurchase, your thought process there.

Number two is update on the CFO search.

Number three is there any way if the debt indicators polled that HSBC and you contractually can separate just any thoughts on that.

And then, finally, the way you are thinking about this upcoming season, where we saw new IRS forecast going forward every year through next year through 2017 they're looking for growth in tax filers next year, about half a percent, what do you think about that and was that out in time to work into your equation in about how your thinking about next year.

Lets go with the debt indicator one first because we had just talked about that a little bit earlier.

Our legal counsel has looked into this many different ways and we feel very confident that there are no outs in the contract with HSBC.

That would terminate -- that would cause the agreement to terminate if the debt indicator were pulled.

And, in fact, in our recent discussions with them, they have reiterated that the partnership worked even better this last tax season than it ever has before and that they intend to honor our contract through fiscal year '13 which is includes the two-year option extensions.

CFO search, we are making very good progress.

We've seen a number of candidates.

We liked a couple in particular, and our goal is to try to wrap that up over the next couple weeks.

On outlook for tax season, you know, I just did see Scott that information when it came up the other day and I think a lot of that is going to be driven off of people's expectations about economic recovery and job recovery, and so frankly, when we look at kind of industry wide things, for next year, as we said in the conversation, without job growth or without some other type of ESA type stimulus or refundable credits that drive people in and force them to file taxes, I think it's going to be tough for those numbers to grow, absent either one or both of those two events occurring.

And then, you know, on a dividend and repurchase piece, so we talked to our major investors on a regular basis, you know, part of that conversation is typically how they view dividends versus repurchase, and, you know, as we look at our dividend yield ratio, it's relatively high.

Now part of that frankly is driven by the fact that the stock prices is lower than we think it ought to be.

But even if it were to get -- the price were to go back up our dividend yield ratio is already pretty high.

And, you know, so we think about how a change in the dividend versus share repurchase signals externally our own views about our business opportunities and our growth potential.

And, you know, I think this is a balancing act.

It's not kind of all one or not the other.

I think it is a healthy thing.

You know, to have dividend growth over time, it puts pressure on management to continue to grow earnings, you know, and however when you -- when you've got opportunities to purchase stock at what you think are great prices, you know, in those situations you would probably error more on the balance of share repurchase.

You know, I think these are things that we kind of regularly evaluate and discuss both from a management team perspective and, more importantly, this is a regular part of our board discussions.

And, you know, there's no absolute one method versus the other, and, you know, we've chosen to say here is the dividend rate we've declared in the past and we'll be opportunistic on share purchases but we'll evaluate that at our next board meeting which is when we decide on our next quarterly dividend.

Thanks for answering all of those Russ.

And at this time I'm showing there are no further questions.

Well thank you very much for your time, everyone.

We appreciate, you know, spending time on the call, and if we don't talk to you beforehand, have a wonderful Fourth of July holiday, thank you.

And this does conclude today's conference call.

You may now disconnect.