H & R Block Inc (HRB) 2011 Q2 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 H&R Block fiscal year '11 Q2 earnings conference call.

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

Derek Drysdale.

Mr.

Drysdale, you have the floor.

Good afternoon, everyone, and thank you for being with us today.

I'm joined by Alan Bennett, our President and CEO; Phil Mazzini, our President of Retail Tax Services; and Jeff Brown, our Chief Financial Officer.

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

In conjunction with today's call there is an accompanying press release and slide presentation which are posted to the Investor Relations section of our website at hrblock.com.

Before we begin, I'd like to remind everyone that comments made today may 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 risk factors, uncertainties and assumptions that are difficult to predict and as a result actual outcomes and results could differ materially.

Please see the risk factors included on this slide as well as 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.

We do have a lot to cover today in our prepared remarks so we anticipate this call will go beyond one hour.

Following our remarks we'll open up the call to questions.

I'll now turn the call over to Alan.

Thank you, Derek, and thanks to all of you who have joined us today.

Earlier we reported a second quarter net loss from continuing operations of $0.35 per share.

A $0.03 improvement to the prior year.

Given the seasonal nature of our business and that we generate all of our earnings in the last four months of the fiscal year, our second quarter results generally do not offer much color on our full year results.

In recent months Jeff, Derek and I have met with many investors and we clearly realize that the outlook for both settlement products for our core tax business and rep and warrant related repurchase obligations for our discontinued mortgage subsidiary, are areas of concern and speculation in the marketplace.

Before we get into plans for the upcoming tax season I'll briefly address both.

First, we remain in negotiations and litigation with HSBC, our provider of financial settlement products.

As a result, we are absolutely limited in what we can say at this time.

This is a complex situation, and we are working hard to have refund anticipation loans available this season.

While we can't speculate as to how this matter will ultimately be resolved, we currently see two possible outcomes.

The first possible outcome is that refund anticipation loans, or RALs, will be available but the economics for us would be lower than previously anticipated.

Under this outcome, while RAL margins would decline, consumer demand for this product would be fulfilled.

Whether the availability of a RAL product would impact our tax return volumes would be heavily influenced by the competitive landscape of financial products.

The second possible outcome is that our RAL provider will not fund refund anticipation loans but we will still be able to offer refund anticipation checks, or RACs, to our clients.

Under this scenario, the economic impact of clients switching from RALs to in-house RACs is relatively neutral to us.

However it is difficult to estimate the overall impact to H&R Block's tax return volume which could be significant if the playing field is uneven and competitors have RALs.

Some of this potential client loss may be offset by the success of our product promotions and advertising, as well as the limited RAL product offering in the overall marketplace.

Due to this uncertainty we cannot determine what the earnings impact might be at this time.

Clients do value our no cash, out-of-pocket and faster access to funds benefits associated with our refund anticipation checks as well as our industry leading H&R Block Emerald Card.

We are diligently pursuing all available avenues and we will provide timely updates as this matter concludes.

Moving to our discontinued mortgage business, Sand Canyon has not seen any adverse change in the level of its claims or payments.

In fact, new claim activity during the second quarter was just $21 million and rep and warrant related losses were approximately $3 million.

Sand Canyon's reserve at October 31, 2010 was $185 million and we have not added to aggregate reserves since the initial reserve of $243 million was established in the spring of 2008.

Later on in the call Jeff will provide a broad overview of Sand Canyon to address many of the questions we have received from shareholders during the quarter.

With that update I'd like to address the external market environment.

As you know, we have not been immune to the sluggish economy, and it continues to present its challenges.

At RSM McGladrey, the accounting consulting and tax industry as a whole remains somewhat soft.

Billable rates and hours remain under some pressure within the industry.

While these forces are pressuring McGladrey's top line, we still expect to substantially grow earnings and margins at McGladrey this year primarily due to the lack of one-time charges that we incurred last year and improved cost controls.

As for the core retail tax business, unemployment in general has not materially improved and remains especially high within our early season core client base.

As a result, we estimate that total filings at the IRS will be flat to slightly down this year.

Phil Mazzini will talk later about our plans at retail to stem the client losses that we experienced in tax seasons 2009 and 2010.

In the digital space our pending acquisition of TaxACT remains under regulatory review, and we are responding to their requests for additional information.

The closing date is not yet finalized but will occur as soon as regulatory approvals are received.

In the meantime, we continue to focus on growing our H&R Block at-home digital tax business.

As you may have noticed, we recently completed the redesign of our website to make it easier for our customer to transact with us, whether it's with our digital or retail business.

We believe the new web design will facilitate client navigation and improve conversion rates this tax season.

In addition we have simplified our online product registration flow to eliminate the barriers where many potential clients dropped off last year before filing their return.

A marketing plan is now finalized and you can expect to see a dramatic change in how we market both our digital and retail products.

In digital you'll see a much more aggressive approach with heavy promotion of our free to drive client acquisition and trial.

And we have aggressive plans on the retail side, as well, which Phil will share with you later on in the call.

Before I conclude I would like to briefly touch on our Emerald prepaid debit card.

We continue to be optimistic about the potential for long-term growth in this space.

Plans to grow our Emerald card business are beginning to solidify around four key opportunities.

Growing the number of clients who take the card in our retail channel, putting a renewed focus around increasing year-round use of the Emerald card by our users, leveraging our bank's prepaid card experience and brand to expand our services to the 40 million underbanked consumers in the United States, and pursuing targeted product offerings to our online and non Block-branded channels.

Although we are solidifying our strategic direction internally and with our regulators, and are beginning to execute our initial tactics, we do not expect these efforts to result in significant short term increases in card volume or revenue this fiscal year.

However, we view this asset as a potential growth engine for acquiring new clients and increasing year-round revenue in the future.

In our retail channel, a significant segment of our tax clients are underbanked and would greatly benefit from our Emerald products.

We have strengthened tax professional training and communications around the benefits of our Emerald card for our clients beyond their tax event.

This renewed focus on increasing year-round use includes offering text messaging services to our clients in which we will send an updated balance to their cell phone after each purchase, and which allows our clients more information, safety, and control over their finances.

We also plan to enhance the value of the product to our clients by providing access to a national surcharge-free ATM network.

As I review the Company's progress since my return in July, I'm pleased with the new organizational structure which emphasizes P&L leadership and better alignment of our resources to P&L owners.

I'm also pleased with our overall preparedness for the upcoming season.

We still have a lot of work to do but I'm confident in the ability of our new management team.

I'll now turn the call over to Phil.

Thank you, Alan, and good afternoon.

As we move closer to the start of the season, we do so knowing that we face significant challenges in addition to the settlement product challenges that Alan referred to.

Today I will start by addressing three of those challenges.

First, the economic environment remains difficult, as Alan mentioned, especially for lower and middle income clients.

These individuals make up the bulk of our client base and especially at the lower end remain jobless at rates as high as double the national average.

Their declining file rates reflect these circumstances.

Second, we face negative momentum that stems from the client losses we've experienced in the early season over the last few years.

These losses reduced the pool of clients from which we retain.

Finally, digital momentum exacerbates our challenges, not necessarily because our prior clients are switching to digital but more so because the shrinking pool of pen and paper consumers, historically a source of new clients for us, are increasingly choosing a digital method to prepare their taxes.

Let me say, while this is an important factor we should not exaggerate its impact.

It's important to note that the assisted tax prep and the do it yourself category mix remains fairly stable.

In fact, the same proportion that chose assisted preparation in tax season 2002 chose assisted tax preparation last year in tax season 2010, 61%.

In spite of these challenges we remain optimistic regarding our retail business's future for a number of reasons.

We possess the strongest brand in tax preparation and the advertising scale to leverage it.

We also possess the strongest retail presence in the industry which helps keep us top of mind.

Most importantly, though, we have more than 100,000 of the best trained tax professionals in the industry who represent the face of H&R Block.

As the tax code becomes increasingly complex with new regulatory changes such as the IRS's return preparer initiative which calls for stricter and higher standards, we find confidence in our well-established training infrastructure.

We continue to leverage that infrastructure to exceed all new standards.

Although the RAL situation remains fluid we also maintain a competitive position with regard to our ability to provide products to our clients.

Our low to moderate income clients continue to value the benefits of these product and our industry leading H&R Block Emerald card offer.

Despite a challenging environment, we continue to work to bring higher value products to consumers at lower costs.

Additionally, our tax professionals remain strong and lasting relationships with millions of clients.

In fact, when clients return to us for more than five years we retain them at 85%.

Clients trust us with one of their most important financial transactions of the year.

The relationship centers around the tax event, typically a refund event, that becomes the time of year when the client is in the strongest cash position.

We believe this relationship, combined with our in-house banking capabilities, represent a significant asset that we've only just begun to tap.

Finally, as our off season results show, we continue to demonstrate our ability to manage our costs down.

The cost conscious culture bodes well as we enter the season.

Now I would like to briefly walk you through our plans for the upcoming season and highlight our readiness for it.

As I frame our plan, it's important that I discuss how we intend to improve both our retention fundamentals and our short-term new client growth trends.

I'll start with our retention improvement plans.

Many of you have heard about these plans in the past, so I'll be brief.

But it's important to recognize the significance of these tactics and the role of improving the fundamentals of our business.

Let me review three of our more important tactics in the front desk, tax desk, and call center service area.

First, we continue to upgrade our front desk personnel for the first people our clients see.

Last year we increased front desk coverage hours by 34% and employed a competency exam and a more rigorous interview and training program to improve quality.

Second, for the first time in the Company's history we made a conscious national effort to categorize our tax professional talent by their ability to retain clients.

Last year we moved 800,000 clients to higher performing tax professionals and we'll continue to drive against this tactic this year.

Now third, we've made a number of important improvements across the organization to help our contact centers better service clients during remote touch points.

These improvements included better agent quality training, better service execution to prevent the need for remote contact in the first place, better equipment, and infusion of service oriented leadership.

These three tactics drove satisfaction issue resolution measures higher last year.

We are confident that these tactics will continue to improve the likelihood that our clients will recommend our brand and our tax professionals to their friends, family and coworkers, and that they'll drive retention improvements.

Now I'll discuss our plans to boost new client growth in the short term.

We've designed an aggressive plan to grow the number of new clients we serve this upcoming tax season.

The declining base of clients available to retain that I discussed earlier requires us to come to market aggressively in 2011 to stem further losses.

I'll refer to five client drivers.

They include changes to our Emerald Advance program, a new free EZ tax professional sampling program, our early season bank settlement product offerings, a new marketing campaign, and our competitor conversion program.

Let's first discuss our Emerald Advance program which we'll offer to both prior and new clients.

We're ramping this program right now and we've received an enthusiastic client reception to date.

In the past, the program has proved itself as a significant retention and new client generator, so we're optimistic regarding its impact on our new client growth.

Our second client driver is a free Federal EZ tax professional sampling program which we'll promote from the start of the season until February 15th.

This program is not about discounting, and that's important.

It's about driving new clients in to sample our tax professionals with three intentions in mind.

First, provide a risk-free trial incentive so that we can demonstrate the value of a Block tax professional, especially to the 18 to 35 year old client segment, a segment where we maintain strong market share but have experienced share losses recently.

Second, to develop a long-lasting relationship with EZ filers, as 55% of them will file a more complex return within two years as their tax needs change.

And third, and importantly, to monetize the opportunity through client trade-ups to more complex forms and through state returns and other products.

Our ability to monetize this program means a minimal impact on our net average charge which is a subject I'll return to.

So we believe that this program, which we'll support strongly with advertising, will drive not only client growth but sustainable revenue growth, as well.

Given our market test results, we believe this traffic building offer carries little downside risk and significant upside potential given our ability to promote it.

Let's now turn to our early season bank settlement product offerings, our third client driver.

As Alan mentioned, the situation remains fluid, and we're limited as to what we can say regarding our position.

I will say, though, under either of the scenarios that Alan described, or any in between, we intend to use our strengths to compete aggressively in the early season.

Whatever our offering, you can expect us to use our scale to promote it much more aggressively than we did last year.

As I have alluded to throughout, we plan to support our client growth programs with our fourth client driver, a hard hitting behavior driving advertising campaign.

The 2011 marketing approach has been well guided by good learning from last year's second half test initiatives.

We'll come to market with a much tighter focus on the critical client segments and offerings that we need to win.

Without giving it away, the campaign will make it compellingly clear that if you're not using H&R Block for your taxes you're settling, and in these economic times consumers should never settle for less.

The offers and calls to trial action will be clear and will reassert the brand credibility that H&R Block has historically owned.

We're excited about what we feel is a strong business driving campaign that has long-term staying power.

Our fifth and final client driver is a continued effort to convert our competition into H&R Block franchisees.

Last year, we brought about 70,000 returns into our system this way.

This year we'll bring in more than double that figure.

We believe and continue to see evidence that increased regulation and the costs associated with it and the settlement product environment make the industry ripe for consolidation.

Before I conclude, I'd like to briefly discuss pricing.

First, we expect no material change to our overall net average charge, or NAC.

The downward pressure our free EZ program will place on NAC will be mitigated by our ability to monetize the offering and adjustments across our portfolio to bring both 1040-As and 1040s more in line with the relative value we provide in serving our clients in those segments.

A number of factors could impact our NAC throughout the year including complexity changes, client mix, and the level of success in our ability to monetize the EZ offering.

We will closely monitor our NAC throughout the season and take actions as appropriate.

Now in conclusion, no plan comes without risks, especially in the uncertain economic and regulatory environment in which we operate.

However, as a longtime industry leader we plan to leverage our strengths to lead aggressively through these risks.

In October at our national meetings, we outlined our plan to our Company and franchisee partners.

I'm happy to report that we walked away from these meetings more aligned than in any meeting in the past several years.

This alignment strengthens our ability to execute.

We have a clear initiative planned to address growth objectives and to mitigate the major risks we have identified in our environment.

Our brand strength, our significant retail presence, our advertising scale, our longstanding relationships with millions of clients, and our strong alignment contribute to our optimism as we implement our plans for this tax season and our future in general.

At this point I'll turn the call over to Jeff.

Thanks, Phil.

I'll begin by providing a brief recap of our financial results.

As Alan mentioned, our second quarter loss from continuing operations improved by $0.03 per share compared to the prior year.

Our consolidated net loss of $109 million was approximately $20 million better than the prior year and total revenues were down 1% to $323 million.

Our effective tax rate for continuing operations during the quarter was 39% and we continue to believe that our full year tax rate will be approximately the same.

We ended the second quarter with nearly $1 billion of cash and $1.1 billion of total debt.

Stockholders' equity at quarter end was $880 million.

During the second quarter we repurchased and retired 3.5 million shares at a cost of $44 million and ended the quarter with 305 million shares outstanding.

We now have approximately $1.4 billion of share repurchase authorization remaining.

In our Tax Services segment, second quarter revenues grew by 1.5% to $111 million.

Tax preparation fees increased $4 million, or 7%, primarily due to results in Australia in operations and favorable foreign exchange rates.

Our pretax loss of $154 million compared to a pretax loss of $172 million a year ago.

Total expenses fell by $16 million, or nearly 6%, primarily through staff reductions and the closing of certain underperforming retail tax offices.

During the second quarter we sold approximately 130 company-owned offices that we believe will be better operated by franchisees.

Gains on the sale of these offices have been deferred and will mostly be realized in the fourth quarter.

In fiscal 2011 we expect to realize approximately $40 million to $50 million of pretax gains from these sales, compared to $49 million of pretax gains last year.

As a reminder, the rationale for this activity is not about current profit, but rather around market considerations and long-term growth optimization.

In Business Services, RSM McGladrey's revenues fell 1.5% to $203 million.

The segment reported pretax income of more than $8 million compared to pretax income of $200,000 a year ago.

Total expenses fell $11.4 million, or 5.5%, primarily due to reduced compensation in the current year and litigation costs incurred in the prior year.

In Corporate, our pretax loss improved to $29 million compared to a loss of $41 million in the prior year.

Lower losses were due to reduced loss provisions on mortgage loans held for investment as well as corporate expense reductions.

Our static pool of mortgage loans held by our bank continues to wind down.

The net principal balance of mortgage loans declined by approximately $26 million during the quarter to $537 million.

Net loans at quarter end included $312 million previously originated by our discontinued mortgage business.

We continue to see delinquency and loss severity rates level off and our quarterly loan loss provision of $8 million was down by $5 million compared to the prior year.

Our allowance for loan loss was $88 million, or 14% of outstanding principal at October 31st, compared to $96 million or 12.6% a year ago.

Turning to rep and warrant obligations of Sand Canyon, in addition to our normal update on second quarter claim activity, I plan to give a broad overview of this matter generally.

As part of the overview we will attempt to address many of the questions we have received regarding representation and warranty put-back risk.

Let me start with a historical recap of this business.

Sand Canyon, formally known as Option One, was a subprime originator and servicer headquartered in Irvine, California.

H&R Block purchased Sand Canyon in 1997.

Sand Canyon was operated as a separate subsidiary.

It secured independent warehouse lines to fund its originations, and its management team set underwriting standards and made loan origination and disposition decisions.

Sand Canyon originated loans mainly through a wholesale network of mortgage brokers and was a plain vanilla subprime residential mortgage originator.

It did not originate any home equity lines of credit, negative amortization, or pay option adjustable rate loans.

Second lien loans were minimal, and of the loans originated from 2005 through 2007, 96% were first lien mortgages.

In December of 2007, Sand Canyon stopped originating mortgages, and in April 2008 sold its servicing business to American Home Mortgage.

From the date of its acquisition by H&R Block, through the date it ceased operating as a mortgage loan originator, Sand Canyon originated mortgage loans in the total principal amount of $169 billion.

One-half of this origination volume occurred prior to 2005, and originations for vintage years 2005 through 2007 totaled $84 billion.

I'll discuss this in greater detail in a moment, but we believe there is minimal put-back risk related to loans originated prior to 2005.

As such, my remarks today will focus on originations from the 2005 to 2007 vintage years.

Of the loans originated from 2005 to 2007, 95% were subprime loans.

Approximately 1% were Alt-A loans, and 4% were prime mortgages.

Sand Canyon did not originate mortgage loans with the intent of holding to maturity, but sought to dispose of all loans upon origination.

Mortgage loans were pooled and either sold to whole loan investors or placed in private label securitizations.

About one-third of the loans originated by Sand Canyon from 2005 through 2007 were placed directly into Sand Canyon's securitizations, with the balance sold in whole loan transactions.

And the vast majority of mortgage loans transferred in whole loan sales were subsequently securitized in private label securitizations issued by those whole loan investors.

Of the loans originated from 2005 to 2007, excluding loans that had been either paid in full or loans with no continuing representations and warranties, approximately $2 billion of those loans are held in private label securitizations in which monolines insure one ore more tranches.

$39 billion of those loans are held in private label securitizations with no monoline insurer.

And approximately $500 million were sold to Fannie Mae.

And finally, the remaining $2 billion were sold to whole loan investors which we believe were not placed into a securitization.

Now let me comment on representations and warranties provided by Sand Canyon in connection with the loans it originated.

As most of you may recall, whole loan trades typically had an early payment default provision whereby San Canyon would repurchase loans that defaulted in the first month after the loan's sale.

During fiscal years 2006 through 2008, Sand Canyon repurchased approximately $1.3 billion of loans in the aggregate for early payment default.

Although early payment default provisions have expired, Sand Canyon provided other rep representations and warranties in connection with its disposition of mortgage loans.

Those reps and warrants were not subject to a stated term but would be subject to statutes of limitation applicable to contract claims generally.

The vast majority of claims received by Sand Canyon have alleged breaches of reps and warranties related either to a loan's compliance with applicable underwriting standards established by Sand Canyon at origination or to borrower fraud.

As it relates to representations pertaining to borrower fraud, it is important to note that Sand Canyon included a knowledge qualifier in whole loan sales transactions with institutional investors.

In plain English, for loans sold to whole loan investors, Sand Canyon only has liability for borrower fraud if it had knowledge of the fraud at the time it sold the loans.

This knowledge qualifier existed in roughly two-thirds of San Canyon's origination.

The knowledge qualifier is particularly relevant to claims involving reduced documentation loans where, by definition, Sand Canyon was relying on borrower representations regarding both assets and income, and was not conducting an independent verification of those representations.

The inclusion of reduced documentation loans, which allowed borrowers to obtain a loan without providing proof of their income, were appropriately disclosed to investors.

We have received questions from time to time asking whether stated income loans present a greater put-back risk to Sand Canyon.

Clearly this is not the case because underwriting standards provided to investors which served as the basis for reps and warrants disclosed that income levels were based on the representation of the borrower.

One other important factor to understand as it relates to representations and warranties, is that unlike standard GSE repurchase rights which do not require any correlation between an alleged breach and a loss incurred by the investor, Sand Canyon is only obligated to repurchase a loan for an evidenced breach that materially and adversely affects the value of a mortgage loan or the interest of an investor.

One final thought on representations and warranties.

As a matter of practice, H&R Block typically did not provide guarantees for indemnifications in connection with loans originated and transferred by Sand Canyon.

As such, obligations arising from breaches of reps and warrants are obligations of Sand Canyon alone.

The only exceptions to this practice occurred in the final months preceding Sand Canyon's exit from the mortgage loan origination business when, on a few occasions, buyers of loan pools sold by Sand Canyon required a parent guarantee.

The guarantees were related to Sand Canyon's performance obligations under the applicable agreements and not related to loan performance.

Guarantees remain outstanding on three such pools with original notional amounts of approximately $1.7 billion.

No repurchase claims have been received by Sand Canyon in connection with two of these guaranteed pools representing approximately $1.5 billion of the $1.7 billion since January of 2009.

H&R Block also provided a guarantee of the indemnity obligations of Sand Canyon in connection with the sale of its servicing assets to American Home.

Guarantees and indemnities provided in connection with this transaction were typical of any purchase and sale agreement.

This guarantee in no way obligates H&R Block for the rep and warrant obligations of Sand Canyon to any third party.

It merely says that in the unlikely event that American Home were ever sued for a Sand Canyon rep and warrant default, that Sand Canyon would hold American Home harmless, and that Sand Canyon's parent backstops that very specific and unlikely obligation.

Now let's discuss claim activity.

From May 1st 2008 through October 31st, 2010, Sand Canyon has received claims for alleged breaches of reps and warrants in the total principal amount of $707 million.

Claim activity for the quarter ending October 31st, 2010, was just $21 million.

Because Sand Canyon generally has 60 to 120 days to respond to claims, there are typically open claims at the end of any quarter for which review is pending.

Claims in the principal amount of $121 million were pending review at October 31st, of which approximately $97 million are from private label securitizations relating to rescissions of mortgage insurance, and $24 million are from monoline insurers.

In addition to rep and warrant claims during the second quarter, Sand Canyon and H&R Block, were named, among other defendants, in a lawsuit by the Federal Home Loan Bank of Chicago, alleging securities fraud in securitizations in which FHLB Chicago invested.

In total, the suit references Sand Canyon's securitization bonds that FHLB Chicago purchased totaling $51.6 million.

A principal of $9.4 million has been received on those bonds to date.

At this date we have concluded that a loss related to this matter is not probable.

Sand Canyon's historical claim activity reveals certain trends that we believe are relevant.

Let me highlight now a few of those trends.

Of the total rep and warranty claims asserted against Sand Canyon since May 2008, essentially no claims have involved loans originated in a calendar year prior to 2005.

All claims have been related to loans originated during calendar years 2005 through 2007, with the majority involving 2006 originations.

Moreover, in the most recent 12 months, 96% of asserted claims relate to 2006 and 2007 originations with the concentration of 2006 loans representing nearly 90% of those claims.

We believe this is a trend that will likely continue, and that any future claim activity will likely relate predominantly to 2006 and 2007 originations.

We'd also like to note the claim activity has always been intermittent and there has been no recent activity to suggest that Sand Canyon claims volumes are trending higher.

In fact, during the 30-month period since Sand Canyon exited the business, 62% of all claims received occurred in the first 15 months, and 38% in the most recent 15-month period.

Claims have principally been asserted by three counterparties -- whole loan investors, monoline insurers, and securitization trustees.

Claim volume from whole loan investors has been declining steadily since May 2008, with only $14 million of claims since July 2009.

This is due to the large volume of loans repurchased from these counterparties under early payment default provisions and the subsequent securitizations of these loan pools substantially limiting any direct put-back rights of the whole loan investors.

Sand Canyon has private label securitizations in which various monolines insured one or more tranches, representing $2 billion in loan principal balance.

Sand Canyon has entered into an indemnification agreement dated April 2008 with a single monoline, whereby the counterparty has agreed not to assert claims related to alleged breaches of representations and warranties.

And Sand Canyon has agreed to indemnify this party for covered losses not to exceed $50 million.

This indemnity agreement was given as a part of obtaining the counterparty's consent to Sand Canyon's sale of its servicing business in 2008.

Though disbursements have not been significant, we believe the full amount under this indemnity agreement will ultimately be paid.

Remaining monolines have been active in loan put-backs with the principal amount of claims for the period May 2008 through October 2010 totaling $263 million.

We expect claims from monolines will continue for the foreseeable future.

Claims from securitization trustees predominantly relate to rescissions of mortgage insurance claims, as trustees may assert rep and warrant claims against Sand Canyon upon a denial of coverage by a mortgage insurer.

Claims to date have totaled $157 million and all relate to a single 2006 securitization.

We expect claims related to mortgage insurance rescissions will also continue for the foreseeable future.

Finally, because loans were typically not originated to either prime or Alt-A standards, few loans were sold by Sand Canyon to GSEs.

Loan sales directly to GSEs represented less than 1% of Sand Canyon's origination volume during the period 2005 to 2007.

Sales to GSEs were subject to agreements tailored to Option One's subprime business and underwriting guidelines and not executed under a standard GSE agreement.

Additionally, GSEs purchased bonds from Sand Canyon 2005 to 2007 private label securitizations totaling approximately $7.7 billion.

At October 31st, 2010, these bonds have received principal recoveries of approximately $5 billion, leaving a remaining balance of $2.7 billion.

It's important to note that to date none of these bonds have realized principal losses.

As such, GSE exposure is very limited, and the total principal balance of claims asserted by GSEs in the last two-and-a-half years is only $13 million.

Sand Canyon has and will continue to perform loan by loan reviews of all claims it receives.

Because Sand Canyon is no longer in the business of originating loans, it does not have a practice of making policy adjustments on asserted claims where continuation of key business relationships may be a consideration.

That said, for those claims that conclusively evidence a loan default related to a material breach, Sand Canyon will comply with its contractual obligation.

As I noted before, claims have been asserted generally by three parties -- whole loan investors, monoline insurers, and securitization trustees in connection with mortgage insurance rescissions.

Sand Canyon has denied approximately 83% of these claims.

And loss severity rates on accepted claims have approximated 60%.

Actual losses incurred since May 1st, 2008 have totaled $58 million.

Losses during our most recent quarter totaled just $3 million.

We believe the low level of accepted claims and resulting realized losses relative to asserted claims is a direct reflection of the limited nature of the loan sale reps and warrants provided by Sand Canyon on its subprime originations.

And while we believe this is generally understood, I do think it is worth restating that Sand Canyon never guaranteed the performance of mortgage loans it originated.

And now a few thoughts on how we consider risks of future claims.

Last quarter we disclosed that the unpaid principal balance of all Sand Canyon originations was $50 billion at May 1st, 2008, and $33 billion at June 30th, 2010.

While we frequently get asked for this data, it is not likely the best way to assess exposure to future claims.

As I stated previously, all claims received to date have related to originations in the 2005 to 2007 vintage years.

And the vast majority of those claims have related to the 2006 and 2007 vintage years.

Future claims will likely come from loans originated during those years, but not all originations continue to represent put-back risk.

For example, loans that have to date been paid in full cannot result in a valid claim as the investor suffered no loss.

The principal balance of paid in full loans from 2005 to 2007 vintage years totaled $32.5 billion.

In addition, loans that have either been repurchased or were sold without recourse do not have future put-back risk, either.

Adjusting for paid in full nonrecourse and repurchased loans, the remaining principal for 2005 to 2007 vintage years totals $43.7 billion.

The principal balance for only the 2006 and 2007 vintage years is $27 billion.

Based on historical claim activity to date, we have also observed that accepted claims relate almost exclusively to loans that became delinquent within the first 24 months following origination.

We continue to believe that the longer a loan performs prior to default, the less likely the default was a result of a rep and warranty breach, and instead was more likely a result of external factors.

However, just because a loan experiences an early default does not necessarily mean that there is any breach of a rep and warranty.

Bond holders and other market participants assumed the fully disclosed risk for credit losses of the mortgage securities they purchased backed by subprime loans originated by Sand Canyon.

We believe that a significant portion of the current level of losses in mortgage loans originated by Sand Canyon is the result of external factors and not necessarily a defect of the loan at origination.

These factors include the unprecedented decline in home prices, historic high levels of unemployment, and other trends.

That being said, we wanted to provide performance detail for 2005 to 2007 mortgage loans that have not been paid in full and that remain subject to recourse provisions.

For purposes of illustration, loan performance data has been segmented based on when a default occurred using six-month intervals.

The principal balance of defaults occurring in the first 24 months for originations in the 2005 to 2007 vintage years totals $13.2 billion.

The related principal balance for 2006 and 2007 vintage years only, totaled $9.2 billion.

We believe future claim activity will likely come from these loans.

Sand Canyon estimates losses relating to representation and warranty claims by estimating loan repurchase and indemnification obligations on both known claims and projections of future claims.

Projections of future claims are based on an analysis that includes a combination of reviewing repurchase trends, actual defaults and loss severities, inquiries from various third parties, the terms and provisions of related agreements, and the historical rate of repurchase related to breaches of representations and warranties.

Sand Canyon's reserve methodology considers the probability that individual counterparties will assert future claims.

Sand Canyon records reserves for contingent losses it assesses are probable to occur.

The reserve balance was $243 million at April 30th, 2008, and is $185 million as of October 31st, 2010.

The reserve has been reduced by actual losses during that period of $58 million.

The current reserve includes estimated losses based on projections of future claims from monolines, securitization trustees, and other parties, including losses under the previously mentioned indemnification with one monoline.

So let me summarize by restating a few key points.

Although future claims and related losses cannot be predicted with accuracy, we believe any future claims will likely relate to 2005 to 2007 vintage years and primarily 2006 and 2007.

We also believe any valid claims will likely relate to loans in those years where an event of default occurred within the first 24 months of origination.

Finally, we believe there are key factors that will limit Sand Canyon's exposure to valid rep and warranty breaches.

First, Sand Canyon has virtually no exposure to GSEs, as less than 1% of Sand Canyon's loans were purchased by Fanny Mae.

Second, Sand Canyon never originated home equity lines of credit or other exotic subprime loans, and it originated very few second liens.

Third, as a subprime originator, Sand Canyon's rep and warranties were more limited than would be typical of Alt-A or prime originations, including the presence of a knowledge qualifier in whole loan trades.

Lastly, Sand Canyon is no longer an active originator.

It hasn't originated a loan in three years and has no pressure to maintain any ongoing mortgage relationships.

Operator, we are now ready to take questions.

(Operator Instructions) Your first question comes from the line of Mr.

Kartik Mehta.

Sir, your line is open.

Good afternoon.

This is Grant in for Kartik.

We've been following your suit for injunctive relief against HSBC.

And just considering that they're trying to take advantage of a random policy shift to get out of the contractual obligation, we think that you guys have a lot of momentum on your side.

Given the cancellation of your recent arbitration court date, what concerns do you have that you will not be able to reach a settlement with HSBC?

This is Alan.

And I understand obviously the nature of the question and the nature of the concern this close to tax season.

But this is a very fluid situation.

And litigation with a supplier or a business partner is never really an easy undertaking.

But as you know, in court proceedings like this it's very, very important to maintain secrecy and confidence, and accordingly, as frustrating as it might be for you, and certainly for us, I'm just not going to speculate on outcomes or on even specific issues.

That's fair.

Thanks for providing so much information on the size and makeup of your obligation to Sand Canyon repayment claims.

It was helpful to hear about the actions you've taken to limit the liability at the parent company.

Just given the experiences of the past two years, the various crises pending the bailout, it's become clear that the unexpected can always surprise us, and we've been impressed over time with your ability to set up the contingency plans limiting your exposure.

If there were to be a massive spike in mortgage repayment claims with Sand Canyon above the level you have assessed, what would your ultimate liability be?

Again, we think the reserve we have set up -- this is Alan again, by the way -- the reserve we've set up we feel is adequate based on all the information we have right now.

The reserve balance, as Jeff pointed out, is $185 million.

We also have an additional $300 million of equity in Sand Canyon.

And as most of you know, as background, we purchased the mortgage loan business back in the late 1990s.

We've operated it as a separate business.

It's got its own management team, treasury, legal, accounting functions, loan originations, underwriting processes.

Really, we consider it absolutely a separate subsidiary, with really well financed and with reserves we feel are adequate.

Thank you.

That's helpful.

Your next question comes from the line of Scott Schneeberger.

Thanks.

Good evening.

On the RAL issue with HSBC, we've noticed that you have vacated the trial there.

I'm most concerned about timing here.

A, could you answer on the vacate?

And then B, logistically, has HSBC been maintaining or been satisfying the logistical things it needs to maintain in the case that you do offer RALs this year?

This is Jim Ash and I'll take the first half of that.

There was an entry in the federal court's docket that used the word "vacate" but that's a term that is used to simply mean that the hearing that was scheduled for December 2nd was removed from the court's calendar.

So the matter is still very active and pending before the federal court in St.

Louis.

This is Alan.

So with respect to your second question, the answer is yes.

Okay.

And Alan, could you say, are they on pace?

Are they at the timetable they should be this point of the year with regard to logistics?

Yes.

Okay, thanks.

Then back on that prior question, so the trial is still an option, obviously, but there's no court date set.

So it's simply in the settlement process, and another court, a trial could come up, but right now none is currently scheduled, correct?

That's correct.

Okay.

And then if I could, and then I'll hop out, could you give us an idea of the timing of the second request on the pending TaxACT acquisition?

And then also just on that, is there a management earnout in place if you do, in fact, close that acquisition?

Thanks.

No.

First of all, the answer is that we're working diligently to respond to all requests for information with regards to finalizing that acquisition.

As we mentioned before we've never predicted when it would close.

We've said that if it did close by December 31, it was accretive, and tried to give a range of that accretion.

But we're working diligently to try to resolve this as quickly as we can.

Thanks.

And on the earn-out?

There's no management earnout with respect to this.

The economics of the deal really reflect the timing of it.

The way I would look at this is that much of the economics, the earnings that this Company makes in tax season, like all of us, is heavily in February.

So to the extent this acquisition falls after January 31st, I would say most of the economics for this year would be lost with respect to the earnings.

Okay, thanks.

I'll hop back in line but one clarification real quick.

Your view for pricing at retail this year is for flat.

I just want to clarify that from Phil's comment.

Thanks.

That's right, Scott.

We estimate NAC to be flat or slightly higher, but it really depends on client mix and really the success of our free EZ offer.

And at this time we're not really anticipating any big change up or down versus last year but we'll monitor closely throughout the season.

Thanks.

I'll get back in line.

The next question comes from the line of Mike Millman.

Regarding bank products, why can't you, or to what extent can you offer instant RALs.

I shouldn't say instant RALs, let me change that.

Offer credit lines through your bank, as I think you have in the past, if, indeed, HSBC is not in agreement with you?

This is Kathy Barney, the President of H&R Block Bank.

Currently we offer a personal line of credit that's offered year-round.

We do promote it in the early season or the pre-season of the tax season.

However, as you recall, our own bank is prohibited from offering any kind of refund anticipation loan under Publication 1345 of the IRS regulations.

So we will continue to offer our Emerald Advance product, which is a personal line of credit offered year-round that we promote prior to the tax season, but we won't be offering a new product or modifying that product.

I didn't mean to say that you would be offering a refund anticipation product, but that you might extend your credit product that you just discussed.

So we currently offer that product year-round and have been offering that product year-round for the last four years.

So there's no intention to expand that product if you don't have a RAL product?

We're not going to modify the product at all.

Regarding the question on pricing, for many years you and others in the industry have indicated that there seems to be very little in the way of elasticity.

Why, considering the Company's great need to show some earnings improvement, aren't you considering a price increase, if not a substantial price increase?

Mike, this is Phil.

We really view it as a short term versus long-term question.

Could we raise prices?

Yes, we believe our overall elasticity is relatively unchanged, as you just mentioned.

But of course it varies by client segment.

We chose to hold base prices flat last year, which we believe creates more flexibility in the long term.

And we remain focused on improving our service levels and better articulating our value proposition to our clients, which we think will enhance our pricing power over the long term.

Let me just add one thing to that, too, Michael.

This is Alan.

I think that this is a question that is played out often between analysts and management and even the board and management.

I would say that in the last two years here, losing several million customers, primarily from the early season, has really made us come out with aggressive marketing programs this year to attack the early market.

So whenever we talk -- I always don't like to talk about NAC, because MAC masks some of the actions we're taking here and there.

But we do have price increases in our product lines.

We are taking price action throughout our portfolio.

To the extent that we don't sell a lot of 1040-EZs, you will see price increases.

So I think, when we give guidance here on NAC, for example, it bets that we're going to be successful, we're going to do quite a few of the 1040-EZs.

We don't view the 1040-EZ program as a discount.

We view it as pipeline filler of new tax clients to Block that we need to retain for the long term and monetize as their tax returns become more complex.

So the answer is still, it looks like it's flat on average if we're successful, but I don't want you to think that we've taken last year's price list and rolled into it this year.

I think we've been more creative than that, and our marketing is more pointed towards some of the things we've done in our pricing portfolio.

Maybe just to follow up, tell us, last year how many 1040-EZs did you do, and how did that compare with the prior year when you had higher prices?

So we do about 16% of our returns are EZ returns.

Last year what I'll say is that it was fairly stable, Mike, but we did help stem some of the declines that we've had in that segment.

So you didn't see a big shift, but you saw a slowdown in market share loss in that segment.

One other thing I'd say to that, though, is I think there's a big difference going from X to Y and trying to go to market and say that we're down X% in pricing as opposed to going out and say, "Come in, this is free." I think that's a more compelling message.

So when we talk about how this tax season goes later this year we'll have some of the data to prove success or failure on this, but I think it's a much more compelling message.

It's much more traffic building than some percent off of prior price list.

Yes, we shouldn't compare that at all.

Okay, thank you.

Your next question comes from the line of Vance Edelson.

In the scenario you offered in which you do have HSBC's cooperation, could you share some of the factors that could work in your favor in the RAL business?

Given the loss of debt indicators do you think you can take market share if, for example, you have RAL coverage and other others don't, is that a plausible scenario?

And do you have any work-around solutions that you might be able to employ in lieu of the debt indicators to keep RAL volumes alive?

If you could just speak to credit checks or anything else you might have in mind.

I guess the way I'd answer that, again we're trying to plan internally for all scenarios.

That's the first thing I will say.

I think what we learned in prior years is that the financial product seemed to follow the tax return.

So to the extent that traffic was built through marketing programs or other advertising or local marketing initiatives that the traffic went where they went, and then the financial product went with the traffic.

So what I would say on that is that hopefully the 1040-EZ program can drive traffic to our locations and therefore we can convert some of that increased traffic to more financial products.

That's the way I'm looking at this right now.

With respect to the market landscape, whether we have them and they don't, or whether they have them and we don't is very speculative right now.

I'm comforted by the fact that we do have the refund anticipation checks.

We sell more of those, customers take those in higher percentages than they do the RALs.

Some of that is due to availability of the products last year.

But in any case, it does serve the customers' needs of not any cash out of pocket, and to the extent they don't have bank accounts it accelerates the refund.

And of course with our debit card we're able to load refunds on debit cards and have our customers avoid check cashing fees.

I think our portfolio is strong, and again, we're planning for all scenarios, but it's a very fluid market, and it would be hard to speculate on some of these issues.

Got it.

And then on the SG&A, nice job reducing expense there.

Should we expect a similar ramp in spending during the second half of the fiscal year?

Along the same lines, does the advertising spend go up as you are going to be a little bit more aggressive there, or is it just you're going to be more effective with the advertising?

I'll let Phil comment on advertising spend.

But, yes, I would expect for SG&A you could likely expect trends that you've seen in the first half of the year to continue as we go into the second half.

Okay.

So, in other words, the year-over-year trends?

Because normally it goes up a bit during tax season.

We should expect that again, in other words?

Yes, relative to if you measured it quarter over quarter.

Okay.

And on the advertising?

I would just say that we will come to market with significant share of voice, as we always do.

I'm not going to comment directly on up or down but I will also say that I think the advertising will be much more aggressive this year, much more related to the specific client benefits.

I think we have a lot more to say with the things that we're promoting this year.

And I think our advertising will be much more powerful, even if it was the same dollars, let's say.

But I'm not going to comment on up or down.

Great, and just one more quick one from me.

Could you comment on the tax code complexity?

Granted, it's a fluid situation, but at this point, given what we know, can you give us a qualitative feel for how that might help the average pricing during the season?

Yes, it certainly can impact the average price.

Depending on what happens right now in the legislative area, this could impact our average price.

I think to speculate on it probably doesn't make a lot of sense right now, but certainly there's some opportunity and there's some risk in that area.

I wouldn't say it's significant.

I'll leave it there.

Thanks.

Your next question comes from the line of Vishnu Lekraj.

Good evening.

A quick clarification, Alan.

I think you said in the second scenario for the RAL product, you said RAL will be replaced by RACs, then you said there would be no change to operating profit if that was the case.

Yes.

I think there are a number of scenarios that can play out here.

But in a scenario where others have RALs and we don't, we will have in-house RACs to our bank.

I would say that the economics for those two products, the difference between them is absolutely immaterial to us.

But, what's very difficult to assess is the impact to volumes, and with the volumes would go the RACs.

So the key for us is the traffic.

Being disadvantaged in the marketplace is not a scenario that we would look forward to.

Right.

So let's say everything is the same, and then you replace every RAL with a RAC.

There should be no decrease in operating margin or operating profit, correct?

If we keep every customer that would have come anyway, that is correct.

Okay.

But again, like you said, that's all contingent upon if you can replace one for one.

That's right.

You've got to get them all.

To the extent you lose some customers, the financial products may go with them so we've got to be aggressive in the market.

Okay.

The call has been centered around a lot of near term, short-term issues.

I just want to get a little medium to long term here.

When you talk about your Emerald card ramp-up, do you see that as a replacement for settlement products down the line, maybe five years, ten years down the line?

This is Kathy Barney with H&R Block Bank again.

We certainly feel like that we have a very valuable product with the Emerald card.

It serves a lot of our clients' needs and provides an alternative to them to higher priced financial products.

I think that we have an asset here that is valued, and we expect to grow that.

Whether it replaces settlement products down the line is very difficult to foresee.

There is a true need for just traditional banking products and services that are affordable, and are at no cost or low cost to our client base.

So we'll continue to offer the Emerald card product alongside the products that we offer today.

It's a great addition and value add for our client base.

Again, great job on the expenses and moving up your profits, at least for the second quarter.

How should we think about operating margin moving forward?

Again, we've given no guidance.

Even the beginning of the year with the kind of client losses we've experienced in '09 and '10, we've pretty much withdrawn guidance, it's a show me year.

And now really compounded with the fact that this whole settlement arena is in such flux right now that I think it's even smarter that we pulled the guidance so we're just not going to comment on operating margins right now.

The next question comes from the line of Mike Turner

Hi, good afternoon.

Just another follow-up again on, first, the Emerald card.

What are your plans?

My understanding is that product was only available to existing or repeat clients.

Is that a change going into this year?

Or will there be a change where it will be to just anybody, or am I correct in that thinking?

This is Kathy Barney again.

So we need some work done here in our marketing as the Emerald card has been available to the general public for quite some time now.

We've offered it through different avenues, through our Internet, through other channels as well.

We just haven't had a focus on it up until this point.

We do see that we are focusing on that and growing it outside of our tax channel, as well as promoting it even more heavily within our tax channel, and promoting the use of the Emerald card product year-round.

We have the ability to save our clients a lot of money by offering them this alternative to higher priced financial services.

Okay, thanks.

Also on the repurchases -- thanks, this is a lot of information, frankly, it's a lot to digest, but I haven't seen anybody put out this much on this issue.

Just on page 10, it looks like you originated the $84 billion, and then you back out the $32 billion in presumably principal payments.

The $6 billion in nonrecourse, what does that represent?

It would be a combination of prime originations that would not have had any reps and warrants at the date of origination, or in the case when we repurchased loans and perhaps subsequently sold those in what we sometimes refer to as scratch-and-dent sales, those would be without subsequent recourse, as well.

Okay.

So the $32 billion or $33 billion in paid in full, is that just a net number?

Essentially that's the attrition in the portfolio?

Yes, it would represent an individual loan that has been paid in full, the entire principal balance has been repaid.

Okay.

So that is or is not a net number?

What I'm trying to figure out, does that include net of losses?

The outstanding balance is $44 billion, but $32 billion is paid down.

Really, you've probably had X pay down, and then X losses, so that's really net of losses.

No.

So it would not be net of losses.

That's true principal repayment in full.

Okay.

Thanks.

Maybe I'll follow up off line, would be more helpful.

Thank you.

Operator, I'm showing there are no further questions.

If there are -- it looks like maybe Kartik is back in the queue?

That line is open.

Mr.

Mehta, your line is open.

I'm all set, thank you.

Okay.

Well, everyone, that concludes our call today.

If you have any further questions, please call me at Investor Relations.

Thank you so much for joining us.

This concludes today's conference.

You may now disconnect.