SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
OR
Commission file number 1-6089
(Exact name of registrant as specified in its charter)
4400 Main StreetKansas City, Missouri 64111(Address of principal executive offices, including zip code)
(816) 753-6900(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ü No ___
The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on November 30, 2004 was 164,718,239 shares.
H&R BLOCK, INC.Form 10-Q for the Period Ended October 31, 2004
Table of Contents
H&R BLOCK, INC.
See Notes to Condensed Consolidated Financial Statements
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSUnaudited
(in 000s, except per share amounts)
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(in 000s)
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(dollars in 000s)
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Amortization of intangible assets for the three and six months ended October 31, 2004 was $13.5 million and $26.8 million, respectively. Amortization of intangible assets for the three and six months ended October 31, 2003 was $12.9 million and $24.0 million, respectively. Estimated amortization of intangible assets for fiscal years 2005 through 2009 is $53.6 million, $51.9 million, $43.0 million, $41.2 million and $39.8 million, respectively.
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instruments and are therefore not recorded in our financial statements. The notional value and the contract value of the forward commitments at October 31, 2004 were $3.1 billion and $3.2 billion, respectively. Most of our forward commitments give us the option to under- or over-deliver by five to ten percent.
We use interest rate swaps to reduce interest rate risk associated with non-prime loans in our pipeline prior to disposition of the loans. Interest rate swaps represent an agreement to exchange interest rate payments, effectively converting our fixed financing costs into a floating rate. These contracts increase in value as rates rise and decrease in value as rates fall. The swaps outstanding at October 31, 2004 included a net liability of $3.6 million, while no such swaps were outstanding at April 30, 2004. Changes in the market value of these instruments are included in gains on sales of mortgage assets and totaled a loss of $2.1 million for the three and six months ended October 31, 2004. There were no such swaps outstanding at October 31, 2003, and therefore no income statement impact for the three and six months ended October 31, 2003.
6. Long-Term Debt
On October 26, 2004, we issued $400.0 million of 5.125% Senior Notes under a shelf registration statement. The Senior Notes are due on October 30, 2014, and are not redeemable by the bondholders prior to maturity. The proceeds from the notes will be used to repay our $250.0 million in 63/4% Senior Notes, which were due on November 1, 2004. The remaining proceeds will be used for working capital, capital expenditures, repayment of other debt and other general corporate purposes. The proceeds are included in cash and cash equivalents on the condensed consolidated balance sheet at October 31, 2004.
7. Comprehensive Income
The components of comprehensive income are:
8. Stock-Based Compensation
Effective May 1, 2003, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), under the prospective transition method as described in Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” Had compensation cost for all stock-based compensation plan grants been determined in accordance with the fair value accounting method prescribed under SFAS 123, our net income (loss) and earnings (loss) per share would have been as follows:
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9. Supplemental Cash Flow Information
During the six months ended October 31, 2004, we paid $316.8 million and $37.3 million for income taxes and interest, respectively. During the six months ended October 31, 2003, we paid $170.8 million and $42.7 million for income taxes and interest, respectively.
The following transactions were treated as non-cash investing activities in the condensed consolidated statement of cash flows:
10. Commitments and Contingencies
We maintain unsecured committed lines of credit (CLOCs) to support our commercial paper program and for general corporate purposes. During the second quarter, we replaced our $2.0 billion CLOC with two CLOCs. The two CLOCs are from a consortium of thirty-one banks. The first $1.0 billion CLOC is subject to annual renewal in August 2005, has a one-year term-out provision with a maturity date in August 2006 and has an annual facility fee of ten basis points per annum. The second $1.0 billion CLOC has a maturity date of August 2009 and has an annual facility fee of twelve basis points per annum. These lines are subject to various affirmative and negative covenants, including a minimum net worth covenant.
We offer guarantees under our Peace of Mind (POM) program to tax clients whereby we will assume the cost of additional taxes attributable to tax return preparation error for which we are responsible. In August 2003, we adopted Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21). EITF 00-21 impacts revenue and expense recognition related to tax preparation in our premium tax offices where POM guarantees are included in the price of a completed tax return. Prior to the adoption of EITF 00-21, revenues and expenses related to POM guarantees at premium offices were recorded in the same period as tax preparation revenues. Beginning May 1, 2003, revenues and direct expenses related to POM guarantees are now initially deferred and recognized over the guarantee period based upon historic and actual payment of claims. As a result of the adoption of EITF 00-21, we recorded a cumulative effect of a change in accounting principle of $6.4 million, net of a tax benefit of $4.0 million, as of May 1, 2003. Changes in the deferred revenue liability are as follows:
We have commitments to fund mortgage loans to customers as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. The commitments to fund loans amounted to $2.7 billion and $2.6 billion at October 31, 2004 and April 30, 2004, respectively. External market forces impact the probability of commitments being exercised, and therefore, total commitments outstanding do not necessarily represent future cash requirements.
We have entered into whole loan sale agreements with investors in the normal course of business, which include standard representations and warranties customary to the mortgage banking industry. Violations of these representations and warranties may require us to repurchase loans previously sold. A liability has been established related to the potential loss on repurchase of loans previously sold of $36.0 million and $25.2 million at October 31, 2004 and April 30, 2004, respectively, based on historical experience. Repurchased loans are normally sold in subsequent sale transactions.
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Option One Mortgage Corporation provides a guarantee up to a maximum amount equal to approximately 10% of the aggregate principal balance of mortgage loans held by the Trusts before ultimate disposition of the loans. This guarantee would be called upon in the event adequate proceeds were not available from the sale of the mortgage loans to satisfy the payment obligations of the Trusts. No losses have been sustained on this commitment since its inception. The total principal amount of Trust obligations outstanding as of October 31, 2004 and April 30, 2004 was $3.8 billion and $3.2 billion, respectively. The fair value of mortgage loans held by the Trusts as of October 31, 2004 and April 30, 2004 was $3.9 billion and $3.3 billion, respectively.
We have various contingent purchase price obligations in connection with prior acquisitions. In many cases, contingent payments to be made in connection with these acquisitions are not subject to a stated limit. We estimate the potential payments (undiscounted) total approximately $4.8 million and $7.8 million as of October 31, 2004 and April 30, 2004, respectively. Our estimate is based on current financial conditions. Should actual results differ materially from our assumptions, the potential payments will differ from the above estimate. Such payments, if and when paid, would be recorded as additional goodwill.
We have contractual commitments to fund certain franchises requesting draws on Franchise Equity Lines of Credit (FELCs). Our commitment to fund FELCs as of October 31, 2004 and April 30, 2004 totaled $66.1 million and $27.0 million, respectively. We have a receivable of $42.6 million and $35.9 million, which represents the amounts drawn on the FELCs, as of October 31, 2004 and April 30, 2004, respectively.
We routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees, including obligations to protect counter parties from losses arising from the following: (a) tax, legal and other risks related to the purchase or disposition of businesses; (b) penalties and interest assessed by Federal and state taxing authorities in connection with tax returns prepared for clients; (c) indemnification of our directors and officers; and (d) third-party claims relating to various arrangements in the normal course of business. Typically, there is no stated maximum payment related to these indemnifications, and the term of indemnities may vary and in many cases is limited only by the applicable statute of limitations. The likelihood of any claims being asserted against us and the ultimate liability related to any such claims, if any, is difficult to predict. While we cannot provide assurance that such claims will not be successfully asserted, we believe the fair value of these guarantees and indemnifications is not material as of October 31, 2004.
11. Litigation Commitments and Contingencies
We have been involved in a number of Refund Anticipation Loan (RAL) class actions and putative RAL class action cases since 1990. Although we have successfully defended many such cases, we incurred a pretax expense of $43.5 million in fiscal year 2003 in connection with the settlement of one such case. Several of these cases are still pending and the amounts claimed in some of them are very substantial. To avoid the uncertainty of litigation and the diversion of resources and personnel resulting from the lawsuits, we, the lending bank, and the plaintiffs in the case Joel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., et al. (renamed Lynne A. Carnegie, et al. v. H&R Block, Inc., et al.), Case No. 98-C-2178 in the United States District Court for Northern Illinois, had agreed to a settlement class and a settlement of RAL-related claims on a nationwide basis. Under that settlement, we and the lending bank agreed to each pay $12.5 million toward a $25.0 million settlement fund for the benefit of the class members. The settlement was approved by the District Court in February 2001. Certain class members who had objected to the settlement appealed the order approving the settlement to the Seventh Circuit Court of Appeals. In April 2002, the Court of Appeals reversed the District Court’s order approving the settlement and remanded the matter back to the District Court for further consideration of the fairness and adequacy of the proposed settlement by a new District Court judge. In April 2003, the District Court judge declined to approve the $25.0 million settlement, finding that counsel for the settlement plaintiffs had been inadequate representatives of the plaintiff class and failed to sustain their burden of showing that the settlement was fair. The judge subsequently appointed new counsel for the plaintiffs who filed an amended complaint and a motion for partial summary judgment. In March 2004, the court either dismissed or decertified all of the plaintiffs’ claims other than part of one count alleging violations of the racketeering and conspiracy provision of the Racketeer Influenced and Corrupt Organizations act.
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The case is currently scheduled to go to trial in March 2005. We intend to continue defending the case and the remaining RAL class action litigation vigorously, but there are no assurances as to their outcome.
On September 8, 2004, our Board of Directors approved a proposed settlement of the case Joyce Green, et al. v. H&R Block, Inc., Block Financial Corporation, et al., Case No. 97195023, in the Circuit Court for Baltimore City, Maryland. The proposed settlement provided for each class member to receive a small cash payment and a one-time rebate coupon for tax return preparation services and for the defendants to pay settlement administration costs and court-approved legal fees of class counsel. During the process of finalizing the settlement agreement, the parties were unable to reach agreement regarding certain settlement terms. We intend to continue defending the case vigorously, but there is no assurance as to its outcome.
In addition to the aforementioned cases, we have from time to time been parties to claims and lawsuits arising out of our business operations. These claims and lawsuits include actions by individual plaintiffs, as well as cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. Some of these claims and lawsuits pertain to RALs and our Peace of Mind guarantee program associated with income tax preparation services. Others are claims and lawsuits that we consider to be ordinary, routine litigation incidental to our business (“Other Claims”), including claims and lawsuits concerning the preparation of customers’ income tax returns, the electronic filing of income tax returns, the fees charged customers for various services, the Express IRA program, relationships with franchisees, contract disputes and civil actions, arbitrations, regulatory inquiries and class actions arising out of our business as a broker-dealer and as a servicer of mortgage loans. We believe we have meritorious defenses to each of the Other Claims and we are defending, or intend to defend, them vigorously. While we cannot provide assurance that we will ultimately prevail in each instance, we believe that amounts, if any, required to be paid by us in the discharge of liabilities or settlements will not have a material adverse effect on our consolidated results of operations, cash flows or financial position. Regardless of outcome, claims and litigation can adversely affect us due to defense costs, diversion of management and publicity related to such matters.
It is our policy to accrue for amounts related to legal matters if it is probable that a liability has been incurred and an amount is reasonably estimable. Many of the various legal proceedings are covered in whole, or in part, by insurance.
12. Segment Information
Information concerning our operations by reportable operating segment is as follows:
Our international operations contributed $22.3 million and $28.1 million in revenues for the three and six months ended October 31, 2004, respectively, and $1.2 million of pretax income and $6.6 million
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in pretax losses, respectively. Our international operations contributed $19.1 million and $24.6 million in revenues for the three and six months ended October 31, 2003, respectively, and $0.6 million of pretax income and $5.9 million in pretax losses, respectively. The previously reported International Tax Operations segment has been aggregated with U.S. Tax Operations in the Tax Services segment, and prior year results have been restated to reflect this change.
13. New Accounting Pronouncements
Exposure Draft – Amendment of SFAS 140
The Financial Accounting Standards Board (FASB) intends to reissue the exposure draft, “Qualifying Special Purpose Entities and Isolation of Transferred Assets, an Amendment of FASB Statement No. 140,” during the second quarter of calendar year 2005. The purpose of the proposal is to provide more specific guidance on the accounting for transfers of financial assets to a qualifying special purpose entity (QSPE).
Provisions in the first exposure draft, as well as tentative decisions reached by the FASB during its deliberations, may require us to consolidate our current QSPEs (the Trusts) established in our Mortgage Services segment. As of October 31, 2004, the Trusts had assets and liabilities of $3.8 billion. The provisions of the exposure draft are subject to FASB due process and are subject to change. We will continue to monitor the status of the exposure draft, and consider changes, if any, to current structures as a result of the proposed rules.
14. Condensed Consolidating Financial Statements
Block Financial Corporation (BFC) is an indirect, wholly owned consolidated subsidiary of the Company. BFC is the Issuer and the Company is the Guarantor of the Senior Notes issued on October 21, 1997, April 13, 2000 and October 26, 2004. These condensed consolidating financial statements have been prepared using the equity method of accounting. Earnings of subsidiaries are, therefore, reflected in the Company’s investment in subsidiaries account. The elimination entries eliminate investments in subsidiaries, related stockholder’s equity and other intercompany balances and transactions. The income statement for the three and six months ended October 31, 2003 and statement of cash flows for the six months ended October 31, 2003 and balance sheet as of April 30, 2004 have been adjusted to reflect intercompany royalties between BFC and other subsidiaries. These adjustments have no effect on H&R Block, Inc. (Guarantor) or Consolidated H&R Block.
Condensed Consolidating Income Statements
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Condensed Consolidating Balance Sheets
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Condensed Consolidating Statements of Cash Flows
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
RESULTS OF OPERATIONS
H&R Block is a diversified company delivering tax services and financial advice, investment and mortgage services, and business and consulting services. For nearly 50 years, we have been developing relationships with millions of tax clients and our strategy is to expand on these relationships. Our Tax Services segment provides income tax return preparation services, electronic filing services and other services and products related to income tax return preparation to the general public in the United States, Canada, Australia and the United Kingdom. We also offer investment services through H&R Block Financial Advisors, Inc. (HRBFA). Our Mortgage Services segment offers a full range of home mortgage services through Option One Mortgage Corporation (OOMC) and H&R Block Mortgage Corporation (HRBMC). RSM McGladrey Business Services, Inc. (RSM) is a national accounting, tax and consulting firm primarily serving mid-sized businesses.
Our MissionTo help our clients achieve their financial objectivesby serving as their tax and financial partner.
Key to achieving our mission is the enhancement of client experiences through consistent delivery of valuable services and advice. Operating through multiple lines of business allows us to better meet the changing financial needs of our clients.
The analysis that follows should be read in conjunction with the tables below and the condensed consolidated income statements found on page 2.
OVERVIEW
A summary of our results for the six months ended October 31, 2004 compared to the prior year is as follows:
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TAX SERVICES
This segment primarily consists of our income tax preparation businesses – retail, online and software.
Three months ended October 31, 2004 compared to October 31, 2003
Tax Services’ revenues increased $7.8 million, or 11.8%, for the three months ended October 31, 2004 compared to the prior year.
Tax preparation and related fees increased $5.2 million, or 18.1%, for the current quarter. This increase is due in part to Australian operations, which is currently in the middle of its tax season. Australian tax returns prepared increased 7.0% and the average charge increased 2.4%, resulting in $2.7 million of additional revenues. Revenues also increased $1.2 million due to clients accepting their returns in the current quarter, which were started and/or completed in a previous fiscal year.
Other service revenues increased $1.4 million as a result of additional revenues associated with POM guarantees.
Cost of services for the three months ended October 31, 2004 increased $9.5 million, or 7.1%, from the prior year. Our real estate expansion efforts have contributed to increases in both our occupancy expenses and costs related to additional tax courses offered, which we anticipate will provide us with
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the staffing necessary for the new offices. Compensation and benefits increased $4.8 million primarily due to an increase in the instructors and support personnel needed to offer these additional tax courses, and $1.1 million in increased stock-based compensation for seasonal employees. Additionally, off-season expenses related to the former major franchise territories acquired in the second quarter of fiscal year 2004, increased compensation and benefits $1.0 million. These increases were partially offset by a decrease in payroll tax expenses resulting from rate adjustments implemented by certain states. Occupancy expenses increased $4.5 million as a result of a 9.5% increase in company-owned offices under lease and an 8.2% increase in the average rent. Former major franchise territories contributed $1.9 million of this increase.
Selling, general and administrative expenses increased $2.1 million over the prior year due to increased spending of $6.8 million, primarily related to additional technology projects and marketing efforts for our expanded tax courses. We also saw increases in consulting, travel and intangible amortization expenses. These increases were partially offset by decreases in legal expenses and interest accretion related to legal settlements.
The pretax loss of $134.0 million for the three months ended October 31, 2004 represents a 2.8% increase over the prior year loss of $130.4 million.
Due to the seasonal nature of this segment’s business, operating results for the three months ended October 31, 2004 are not comparable to the three months ended July 31, 2004 and are not indicative of the expected results for the entire fiscal year.
Six months ended October 31, 2004 compared to October 31, 2003
Tax Services’ revenues increased $12.3 million, or 10.9%, for the six months ended October 31, 2004 compared to the prior year.
Tax preparation and related fees increased $8.1 million, or 18.1%, for the six months ended October 31, 2004. This increase is primarily due to a $3.1 million increase related to clients accepting their returns in the current period which were started and/or completed in a previous fiscal year. Australian operations contributed $3.0 million in additional revenues as a result of increases in tax returns prepared of 7.1% and the average charge of 2.5%. Our former major franchise territories, which are now being operated as company-owned, contributed $2.0 million in additional tax preparation and related fees.
Other service revenues increased $4.2 million primarily as a result of additional revenues associated with POM guarantees.
Revenues earned during the current year in connection with RALs declined $5.4 million as a result of the RAL waiver agreement in the prior year.
Cost of services for the six months ended October 31, 2004 were up $21.4 million, or 8.8%, from the prior year. Compensation and benefits increased $7.7 million primarily due to $3.1 million more in off-season expenses incurred related to former major franchise territories acquired in the second quarter of fiscal year 2004. Increased numbers of instructors and support personnel needed to operate the higher number of tax courses offered this year also contributed to the increase. These increases were partially offset by a decrease in payroll tax expenses resulting from rate adjustments implemented by certain states. Occupancy expenses increased $11.2 million as a result of a 9.0% increase in company-owned offices under lease and an 8.3% increase in the average rent. Former major franchise territories contributed $4.8 million of this increase.
Selling, general and administrative expenses increased $7.0 million over the prior year due to increased spending of $10.3 million, primarily as a result of additional technology and marketing efforts undertaken in the current year. We also saw increases in consulting, travel and intangible amortization expenses. These increases were partially offset by decreases in legal expenses and in interest accretion related to legal settlements.
The pretax loss of $247.0 million for the six months ended October 31, 2004 represents a 7.4% increase over the prior year loss of $230.0 million.
Fiscal 2005 outlook
Our fiscal year 2005 outlook for the Tax Services segment is unchanged from the discussion in our April 30, 2004 Form 10-K and our July 31, 2004 Form 10-Q. We are on target to open between 650 and
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700 stand-alone offices across our company-owned and franchise network, and approximately 400 additional Wal-Mart locations for the upcoming tax season.
RAL Litigation
We have been named as a defendant in a number of lawsuits alleging that we engaged in wrongdoing with respect to the RAL program. We believe we have strong defenses to the various RAL cases and will vigorously defend our position. Nevertheless, the amounts claimed by the plaintiffs are, in some instances, very substantial, and there can be no assurances as to the ultimate outcome of the pending RAL cases, or as to the impact of the RAL cases on our financial statements. See additional discussion of RAL Litigation in note 11 to the condensed consolidated financial statements.
MORTGAGE SERVICES
This segment is primarily engaged in the origination of non-prime mortgage loans through an independent broker network, the origination of prime and non-prime mortgage loans through a retail office network, the sale and securitization of mortgage loans and residual interests, and the servicing of non-prime loans.
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Mortgage Services’ revenues decreased $58.5 million, or 17.2%, for the three months ended October 31, 2004 compared to the prior year. Revenues decreased as a result of a decline in gains on sales of mortgage loans.
The following table summarizes the key drivers of gains on sales of mortgage loans:
Gains on sales of mortgage loans declined $66.3 million primarily as a result of increased price competition and poorer execution in the secondary market. Market interest rates, based on a two-year swap, increased from 2.19% last year to 2.94% at the end of the current quarter, up 74 basis points. However, our WAC declined five basis points from the prior year, resulting in a decline of 113 basis points in our gross margin, to 2.83% from 3.96% last year. Additionally, direct origination expenses increased $12.5 million, primarily due to increases in broker incentives and origination volume. During the current quarter, we reclassified the accretion on our beneficial interest in Trusts, which includes actual cash received from the Trusts in excess of those estimated, from interest income to gain on sale. This change was made to more accurately reflect the characteristics of the proceeds received by the beneficial interest holders upon disposition of the loans by the Trusts. Amounts reclassified from interest income to gains on sales for the three months ended October 31, 2003 totaled $41.3 million. This change had no impact on our net income as previously reported.
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The following table summarizes the key drivers of loan servicing revenues:
Loan servicing revenues increased $10.2 million, or 19.8%, compared to the prior year. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the three months ended October 31, 2004 increased $14.5 billion, or 39.4%, to $51.3 billion.
Accretion of residual interests of $32.2 million for the three months ended October 31, 2004 represents a decrease of $4.7 million from the prior year. This decrease is primarily due to the sale of previously securitized residual interests during fiscal year 2004, which eliminated future accretion on those residual interests and reduced the balance of residual interests from $317.6 million at October 31, 2003 to $261.5 million at October 31, 2004.
During the second quarter of fiscal year 2005, our residual interests continued to perform better than expected compared to internal valuation models. We recorded favorable pretax mark-to-market adjustments, which increased the fair value of our residual interests $47.1 million during the quarter. These adjustments were recorded, net of write-downs of $11.7 million and deferred taxes of $13.5 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests. Future changes in interest rates or other assumptions, based on market conditions or actual loan pool performance, could cause additional adjustments to the fair value of the residual interests and could cause changes to the accretion of these residual interests in future periods. Favorable mark-to-market adjustments on low original value residuals will generally not be accreted into revenues until the residual interest begins to cash flow.
Total expenses for the three months ended October 31, 2004, increased $19.3 million, or 12.4%, over the year-ago quarter. This increase is partially due to $5.3 million in increased compensation and benefits as a result of a 36.1% increase in sales associates. We did not achieve the level of loan production in our second quarter that we were staffed to support. Occupancy expenses increased as a result of new branch offices opened since October of last year. Other expenses increased $7.6 million for the current quarter, primarily due to a $3.6 million increase in consulting expenses. Costs related to servicing of mortgage loans increased $4.6 million as a result of a higher average servicing portfolio during the three months ended October 31, 2004.
Pretax income decreased $77.8 million to $106.2 million for the three months ended October 31, 2004.
Three months ended October 31, 2004 compared to July 31, 2004
Mortgage Services’ revenues increased $13.5 million, or 5.0%, for the three months ended October 31, 2004, compared to the first quarter. Revenue increased due to higher accretion on residual interests, a decline in impairments of residual interests and increased servicing revenues.
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Gains on sales of mortgage loans decreased $0.9 million primarily as a result of lower origination volumes. Loan origination volumes decreased 4.5% from the first quarter primarily due to increased price competition. This decrease was offset by an increase in our gross margin and a $16.6 million decline in direct origination expenses. Market interest rates have decreased nine basis points since the first quarter, however during the quarter, our WAC increased 25 basis points, resulting in an 11 basis point improvement in our gross margin. Amounts reclassified from interest income to gains on sales for the three months ended July 31, 2004 totaled $44.6 million. This change had no impact on our net income as previously reported.
Impairments of residual interests in securitizations of $3.4 million were recognized during the first quarter.
Loan servicing revenues increased $3.1 million, or 5.2%, compared to the first quarter. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the three months ended October 31, 2004 increased $3.8 billion, or 8.0%.
Accretion of residual interests of $32.2 million represents an increase of $6.5 million over the preceding quarter. This increase is due to write-ups in the related asset values during the first half of fiscal year 2005.
Total expenses of $175.4 million for the current quarter increased $0.8 million compared to the first quarter. Other expenses increased $5.7 million for the current quarter, primarily due to a $2.9 million increase in consulting expenses, a $1.5 million increase in allocated expenses, and increases in depreciation and other expenses. This increase was offset by a $7.2 million decline in compensation and benefits, primarily as a result of decreased incentive compensation expenses.
Pretax income increased $12.7 million, or 13.5%, for the three months ended October 31, 2004 compared to the preceding quarter.
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Mortgage Services’ revenues decreased $83.0 million, or 13.1%, for the six months ended October 31, 2004 compared to the prior year. Revenues decreased primarily as a result of a decline in gains on sales of mortgage loans.
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Gains on sales of mortgage loans declined $100.9 million as a result of increased price competition, poorer execution in the secondary market and higher loan origination costs. Market interest rates have increased 106 basis points since April, however our WAC has only increased 27 basis points from 7.06% at April 30, 2004, resulting in a decline in our gross margin of 126 basis points from last year. Additionally, direct origination expenses increased $58.9 million, primarily due to increases in broker incentives and origination volume. Amounts reclassified from interest income to gains on sales for the six months ended October 31, 2003 totaled $68.3 million. This change had no impact on our net income as previously reported.
Impairments of residual interests in securitizations of $3.5 million were recognized in the current period, compared to $11.1 million for the six months ended October 31, 2003.
Loan servicing revenues increased $20.8 million, or 20.8%, compared to the prior year. The increase reflects a higher loan-servicing portfolio. The average servicing portfolio for the six months ended October 31, 2004 increased $14.5 billion, or 41.7%.
Accretion of residual interests of $57.8 million for the six months ended October 31, 2004 represents a decrease of $13.1 million from prior year. This decrease is primarily due to the sale of previously securitized residual interests during fiscal year 2004, which eliminated future accretion on those residual interests.
During the first half of fiscal year 2005, our residual interests continued to perform better than expected compared to internal valuation models. We recorded favorable pretax mark-to-market adjustments, which increased the fair value of our residual interests $113.5 million during the year. These adjustments were recorded, net of write-downs of $24.7 million and deferred taxes of $33.9 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests.
Total expenses for the six months ended October 31, 2004, increased $65.1 million, or 22.9%, over the prior year. This increase is primarily due to $29.0 million in increased compensation and benefits as a
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result of a 36.1% increase in sales associates. We did not achieve the level of loan production in the current year that we were staffed to support. Other expenses increased $19.7 million for the current period, primarily due to a $6.1 million increase in consulting expenses, a $3.7 million increase in allocated expenses, $2.4 million in additional travel expenses and increases in depreciation and other expenses. Costs related to servicing of mortgage loans increased $14.0 million as a result of a higher average servicing portfolio.
Pretax income decreased $148.1 million to $199.7 million for the six months ended October 31, 2004.
Due to continued pressure on our margins, our Mortgage Services segment fiscal year 2005 outlook has declined from the discussion in our April 30, 2004 Form 10-K and our July 31, 2004 Form 10-Q. Based on these assumptions, we expect our mortgage segment pretax income to decline approximately 30% from fiscal year 2004, excluding the gain on sale of previously securitized residual interests. We are investing in technology and seeking other alternatives to lower our cost of origination. Beginning late in our fourth quarter and then more meaningfully in fiscal year 2006, we expect to realize a 50 to 75 basis point improvement in our overall cost of origination, including the effect of potentially higher origination volumes.
BUSINESS SERVICES
This segment offers middle-market companies accounting, tax and consulting services, wealth management, retirement resources, payroll services, corporate finance and financial process outsourcing.
Business Services – Operating Statistics
Business Services’ revenues for the three months ended October 31, 2004 increased $20.0 million, or 18.4%, from the prior year. This increase was primarily due to a $16.6 million increase in accounting,
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tax and consulting revenues resulting from an increase in the net collected rate per hour and a 15.3% increase in chargeable hours. The increase in chargeable hours is primarily due to the favorable market conditions for all of our core services and the demand for consulting and risk management services. Other service revenues increased $1.5 million as a result of growth in our financial process outsourcing business.
Other revenues increased $4.9 million as a result of increases in reimbursable expenses billed to clients and contractor revenues. Capital markets revenues declined $3.0 million as a result of a 4.2% decrease in the number of business valuation projects.
Total expenses increased $22.2 million, or 19.9%, for the three months ended October 31, 2004 compared to the prior year. Compensation and benefits increased $15.2 million, primarily as a result of increases in the average wage per employee, which is being driven by marketplace competition for professional staff, and in the number of personnel. Selling, general and administrative expenses increased $5.1 million primarily due to increased recruiting expenses and additional costs associated with our strategic growth initiatives. A portion of the increases in each expense category is attributable to investments we are making in early-stage businesses within this segment.
The pretax loss for the three months ended October 31, 2004 was $4.9 million compared to $2.7 million in the prior year.
Business Services’ revenues for the six months ended October 31, 2004 increased $30.6 million, or 14.8%, from the prior year. This increase was primarily due to a $24.1 million increase in accounting, tax and consulting revenues resulting from an increase in the net collected rate per hour and a 10.0% increase in chargeable hours. Other service revenues increased $3.9 million due to the acquisition of our financial process outsourcing business in the second quarter of last year, coupled with baseline growth in this business. Other revenues increased $6.4 million as a result of increases in reimbursable expenses billed to clients and contractor revenues. Capital markets revenues declined $3.8 million as a result of a 13.9% decrease in the number of business valuation projects.
Total expenses increased $36.2 million, or 16.7%, for the six months ended October 31, 2004 compared to the prior year. Compensation and benefits increased $28.2 million, primarily as a result of increases in the average wage per employee, which is being driven by marketplace competition for professional staff, and the number of personnel. Other cost of services increased as a result of higher legal fees and settlements, coupled with higher reimbursable expenses billed to clients. Selling, general and administrative expenses increased $4.6 million primarily due to increased recruiting expenses and additional costs associated with our strategic growth initiatives. A portion of the increases in each expense category is attributable to investments we are making in early-stage businesses within this segment.
The pretax loss for the six months ended October 31, 2004 was $15.0 million compared to $9.4 million in the prior year.
Our fiscal year 2005 outlook for our Business Services segment is unchanged from the discussion in our April 30, 2004 Form 10-K and our July 31, 2004 Form 10-Q.
INVESTMENT SERVICES
This segment is primarily engaged in offering advice-based brokerage services and investment planning. Our integration of investment advice and new service offerings are allowing us to shift our focus from a transaction-based client relationship to a more advice-based focus.
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Investment Services – Operating Statistics
Investment Services’ revenues, net of interest expense, for the three months ended October 31, 2004 increased $0.7 million, or 1.4%.
Transactional revenue, which is based on individual securities transactions, decreased $2.7 million, or 11.9%, from the prior year due primarily to a 17.0% decline in trading volume resulting from the weak
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investment climate. This decline was partially offset by an increase in average revenue per trade of 7.7% over the prior year.
Annuitized revenue, which is based on sales of mutual fund, insurance, fee based products and unit investment trusts, increased $3.2 million, or 23.0%, due to increased sales of annuities and mutual funds. The shift in revenues between transactional and annuitized revenues illustrates our continued move toward an advice-based focus.
Productivity averaged approximately $148,000 per advisor during the current quarter compared to $155,000 per advisor in the prior year. This decline is primarily attributable to market conditions.
Other service revenue declined $3.4 million, or 33.9%, from the prior year due to lower underwriting fees related to fixed income products.
Margin interest revenue increased 24.6% from the prior year, which is primarily a result of a 14.8% increase in average margin balances and slightly higher rates.
Cost of services increased $4.7 million, or 14.8%, primarily as a result of $5.6 million of additional compensation and benefits. This increase is primarily due to higher commission rates than the prior year and financial incentives for new advisors.
Selling, general and administrative expenses increased $5.3 million over the prior year primarily as the result of a $6.0 million write-down of a branch office facility and an increase of $1.7 million in legal expenses, partially offset by gains of $1.0 million on the disposition of certain assets and a $1.2 million decrease in incentive compensation expenses.
The pretax loss for Investment Services for the second quarter of fiscal year 2005 was $24.6 million compared to the prior year loss of $15.3 million.
Investment Services’ revenues, net of interest expense, for the three months ended October 31, 2004 were essentially flat compared to the preceding quarter.
Transactional revenue was also flat compared to the preceding quarter, primarily due to a 6.3% decline in trading volume offset by a 4.5% increase in average revenue per trade. Annuitized revenues declined $1.3 million, or 7.2%, due to decreased sales of annuities and mutual funds.
A total of 72 new advisors were recruited during the quarter and recruiting efforts are expected to increase throughout the year. However, our total advisor count declined from 997 to 982 during the period as our recruiting efforts were offset by advisor attrition.
Margin interest revenue increased 14.6% from the preceding quarter, which is primarily a result of higher interest rates, partially offset by a 1.3% decrease in average margin balances.
Cost of services declined $3.0 million primarily due to a $1.8 million reduction in compensation and benefits, primarily due to lower production revenues.
Selling, general and administrative expenses increased $9.2 million from the preceding quarter, primarily due to the write-down of a branch office facility, decreased gains on the disposition of assets, and increased legal expenses.
The pretax loss for the Investment Services segment was $24.6 million, compared to a loss of $18.3 million in the first quarter.
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Investment Services’ revenues, net of interest expense, for the six months ended October 31, 2004 decreased $2.4 million, or 2.2%. The decrease is primarily due to the weak investment climate.
Transactional revenue decreased $8.2 million, or 17.1%, from the prior year due primarily to a 15.6% decline in trading volume. This decline was marginally offset by an increase in the average revenue per trade.
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Annuitized revenues increased $8.9 million, or 33.2%, due to increased sales of annuities and mutual funds. The shift in revenues from transactional to annuitized demonstrates our continued move toward an advice-based focus. Additionally, we are seeing our new recruits coming in with more of an advice-based background, which will further support our efforts.
Other service revenue declined $5.1 million, or 28.4%, from the prior year due to fewer fixed income underwriting offerings.
Margin interest revenue increased 13.3% from the prior year, which is primarily a result of a 16.9% increase in average margin balances. Margin balances have increased from an average of $508 million for the six months ended October 31, 2003 to $594 million in the current period.
Total expenses increased $11.4 million, or 8.2%, primarily as a result of a $6.5 million increase in cost of services. During the current year we incurred $9.0 million of additional compensation and benefits primarily due to a higher average commission rate than the prior year and financial incentives for new advisors. This increase was partially offset by a decline in depreciation costs as a result of the consolidation of field offices. Other cost of services declined as a result of a reduction in property taxes as field offices were sold over the past year.
Selling, general and administrative expenses increased $4.8 million over the prior year primarily as the result of the $6.0 million write-down of a branch office facility and an increase of $2.7 million in legal expenses. This increase was partially offset by a decrease in incentive compensation expenses and gains of $4.2 million on the disposition of certain assets.
The pretax loss for Investment Services was $42.8 million compared to the prior year loss of $29.1 million.
In our April 30, 2004 Form 10-K and our July 31, 2004 Form 10-Q, we indicated our goal was to hire between 250 and 300 experienced advisors by the end of fiscal year 2005. As of the end of our second quarter, we have achieved our planned recruiting levels. We remain optimistic that we will reach our year-end recruiting goal, however we are experiencing higher advisor attrition than we planned. Additionally, we indicated that we expected to see continued financial improvements, but still report a loss for fiscal year 2005. Given our performance to date and revised internal forecasts, we expect our fiscal year 2005 pretax loss to be slightly higher than the prior year.
CORPORATE
This segment consists primarily of corporate support departments, which provide services to our operating segments. These support departments consist of marketing, information technology, facilities, human resources, executive, legal, finance, government relations and corporate communications. Support department costs are generally allocated to our operating segments. Our captive insurance, franchise financing and small business initiative subsidiaries are also included within this segment.
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Corporate expenses increased $10.8 million primarily due to new business development activities that resulted in higher allocations from the information technology, legal and human resource departments, and increases in consulting and insurance costs.
Marketing department expenses increased $2.3 million, or 41.6%, primarily due to additional advertising for tax courses. Other department expenses increased primarily due to $3.7 million of additional stock-based compensation expenses and increases in the cost of employee insurance and supply sales to franchises.
The pretax loss was $28.7 million, compared with last year’s second quarter loss of $18.4 million.
Due to the nature of this segment, the three months ended October 31, 2004 are not comparable to the three months ended July 31, 2004 and are not indicative of the expected results for the entire fiscal year.
Corporate expenses increased $10.1 million primarily due to new business development activities that resulted in increases in consulting and insurance costs, as well as increased allocations from the information technology, legal and human resource departments.
Information technology department expenses increased $2.5 million, or 4.9%, primarily due to an increase in resources needed to support additional projects on behalf of operating segments and other support departments. Marketing department expenses increased $3.2 million, or 39.1%, primarily due to additional advertising for tax courses. Other department expenses increased primarily due to $7.2 million of additional stock-based compensation expenses, increases in the cost of employee insurance and additional supply sales to the operating segments.
The pretax loss was $53.4 million, compared with last year’s loss of $43.4 million.
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FINANCIAL CONDITION
These comments should be read in conjunction with the condensed consolidated balance sheets and condensed consolidated statements of cash flows found on pages 1 and 3, respectively.
CAPITAL RESOURCES & LIQUIDITY BY SEGMENT
Our sources of capital include cash from operations, issuances of common stock and debt. We use capital primarily to fund working capital requirements, pay dividends, repurchase our shares and acquire businesses.
Cash From Operations. Cash used in operations totaled $675.1 million and $463.4 million for the six months ended October 31, 2004 and 2003, respectively. The increase in cash used in operating activities is primarily due to Tax Services and income tax payments. Tax Services used $45.9 million more in cash for off-season costs and working capital requirements compared to the six months ended October 31, 2003. Additionally, income tax payments totaled $316.8 million during the current year, an increase of $145.9 million over the prior year, due to a change in a tax accounting method, which resulted in the acceleration of taxable income within our Mortgage Services segment.
Issuance of Common Stock. We issue shares of common stock, in accordance with our stock-based compensation plans, out of treasury shares. Proceeds from the issuance of common stock totaled $53.9 million and $59.9 million for the six months ended October 31, 2004 and 2003, respectively.
Debt. On October 26, 2004, we issued $400.0 million of 5.125% Senior Notes under a shelf registration statement. The Senior Notes are due on October 30, 2014, and are not redeemable by the bondholders prior to maturity. The proceeds from the notes will be used to repay our $250.0 million in 6¾% Senior Notes, which were due on November 1, 2004. The remaining proceeds will be used for working capital, capital expenditures, repayment of other debt and other general corporate purposes. The proceeds are included in cash and cash equivalents on the condensed consolidated balance sheet at October 31, 2004.
As of October 31, 2004, we had commercial paper borrowings of $316.1 million outstanding. Commercial paper issuance during the six months supported various cash requirements including share repurchases, income taxes, annual incentive compensation obligations and other off-season working capital needs.
Dividends. Dividends paid totaled $70.0 million and $68.1 million for the six months ended October 31, 2004 and 2003, respectively.
Share Repurchases. On June 9, 2004, our Board of Directors approved an authorization to repurchase 15 million shares. This authorization is in addition to the authorization of 20 million shares on June 11, 2003. During the six months ended October 31, 2004, we repurchased 11.2 million shares pursuant to these authorizations at an aggregate price of $527.5 million or an average price of $46.98 per share. There are 15.1 million shares remaining under these authorizations at October 31, 2004. We plan to continue to purchase shares on the open market in accordance with these authorizations, subject to various factors including the price of the stock, the availability of excess cash, our ability to maintain liquidity and financial flexibility, securities laws restrictions and other investment opportunities available.
Restricted Cash. We hold certain cash balances that are restricted as to use. Cash and cash equivalents — restricted totaled $496.8 million at October 31, 2004. Investment Services held $454.0 million of this total segregated in a special reserve account for the exclusive benefit of customers. Investment Services’ restricted cash balance has fallen from $531.6 million at the beginning of fiscal year 2005. Restricted cash of $19.2 million at October 31, 2004 held by Business Services is related to funds held to pay payroll taxes on behalf of its customers. Restricted cash held by Mortgage Services totaled $23.6 million and is held for outstanding commitments to fund mortgage loans.
Segment Cash Flows. A condensed consolidating statement of cash flows by segment for the six months ended October 31, 2004 follows. Generally, interest is not charged on intercompany activities between segments.
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Net intercompany activities are excluded from investing and financing activities within the segment cash flows. We believe that by excluding intercompany activities, the cash flows by segment more clearly depicts the cash generated and used by each segment. Had intercompany activities been included, those segments in a net lending situation would have been included in investing activities, and those in a net borrowing situation would have been included in financing activities.
Tax Services. Tax Services has historically been our largest provider of annual operating cash flows. The seasonal nature of Tax Services generally results in a large positive operating cash flow in the fourth quarter. Tax Services used $297.9 million in its first and second quarter operations to cover off-season costs and working capital requirements.
Mortgage Services. This segment primarily generates cash as a result of the sale and securitization of mortgage loans and residual interests, and as its residual interests begin to cash flow. Mortgage Services provided $41.9 million in cash from operating activities and $50.0 million in cash from investing activities primarily related to cash received from residual interests.
Gains on sales. Gains on sales of mortgage loans and related assets totaled $366.6 million, with the cash received primarily recorded as operating activities. The percentage of cash proceeds we receive from our capital market transactions, which are included within the gains on sales of mortgage assets, is reconciled below.
Warehouse Funding. To finance our prime originations, we utilize an on-balance sheet warehouse facility with capacity up to $25 million. This annual facility bears interest at one-month LIBOR plus 140 to 200 basis points. As of October 31, 2004 and April 30, 2004 the balance outstanding under this facility was $3.6 million and $4.0 million, respectively.
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To fund our non-prime originations, we utilize five off-balance sheet warehouse Trusts. The facilities used by the Trusts had a total capacity of $8.0 billion as of October 31, 2004. The Mortgage Services segment is planning to implement a $3.0 billion on-balance sheet commercial paper conduit program by the end of fiscal year 2005. At that time, we will reduce the warehouse facilities to $7.0 billion. This will bring total available warehouse capacity to approximately $10.0 billion.
We believe the sources of liquidity available to the Mortgage Services segment are sufficient for its needs.
Business Services. Business Services funding requirements are largely related to receivables for completed work and “work in process.” We provide funding sufficient to cover their working capital needs. This segment used $16.4 million in operating cash flows during the first half of the year.
Investment Services. Investment Services, through HRBFA, is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers.
At October 31, 2004, HRBFA’s net capital of $121.2 million, which was 18.6% of aggregate debit items, exceeded its minimum required net capital of $13.0 million by $108.2 million. During the first half of fiscal year 2005, we contributed additional capital of $10.0 million, even though HRBFA was in excess of the minimum net capital requirement, and we may continue to do so in the future.
In the first half of fiscal year 2005, Investment Services provided $25.7 million from its operating activities primarily due to the timing of cash deposits that are restricted for the benefit of customers.
Liquidity needs relating to client trading and margin-borrowing activities are met primarily through cash balances in client brokerage accounts and working capital. We believe these sources of funds will continue to be the primary sources of liquidity for Investment Services. Stock loans have historically been used as a secondary source of funding and could be used in the future, if warranted.
Pledged securities at October 31, 2004 totaled $48.0 million, an excess of $5.0 million over the margin requirement. Pledged securities at the end of fiscal year 2004 totaled $46.3 million, an excess of $7.9 million over the margin requirement.
We believe the funding sources for Investment Services are stable. Liquidity risk within this segment is primarily limited to maintaining sufficient capital levels to obtain securities lending liquidity to support margin borrowing by customers.
OFF-BALANCE SHEET FINANCING ARRANGEMENTS
Substantially all non-prime mortgage loans we originate are sold daily to the Trusts. The Trusts purchase the loans from us utilizing five warehouse facilities, arranged by us. The warehouse facilities were increased to $8.0 billion during the second quarter, bear interest at one-month LIBOR plus 50 to 200 basis points and expire on various dates during the year.
There have been no other material changes in our off-balance sheet financing arrangements from those reported at April 30, 2004 in our Annual Report on Form 10-K.
COMMERCIAL PAPER ISSUANCE
We maintain unsecured CLOCs to support our commercial paper program and for general corporate purposes. During the second quarter, we replaced our $2.0 billion CLOC with two CLOCs. The two CLOCs are from a consortium of thirty-one banks. The first $1.0 billion CLOC is subject to annual renewal in August 2005, has a one-year term-out provision with a maturity date in August 2006 and has an annual facility fee of ten basis points per annum. The second $1.0 billion CLOC has a maturity date of August 2009 and has an annual facility fee of twelve basis points per annum. These lines are subject to various affirmative and negative covenants, including a minimum net worth covenant. These CLOCs are for working capital use, general corporate purposes and commercial paper back up.
At October 31, 2004, there was no commercial paper outstanding under the Block Canada commercial paper program.
There have been no other material changes in our commercial paper program from those reported at April 30, 2004 in our Annual Report on Form 10-K.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
There have been no material changes in our contractual obligations and commercial commitments from those reported at April 30, 2004 in our Annual Report on Form 10-K.
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REGULATORY ENVIRONMENT
There have been no material changes in our regulatory environment from those reported at April 30, 2004 in our Annual Report on Form 10-K.
FORWARD-LOOKING INFORMATION
In this report, and from time to time throughout the year, we share our expectations for our future performance. These forward-looking statements are based upon current information, expectations, estimates and projections regarding the Company, the industries and markets in which we operate, and our assumptions and beliefs at that time. These statements speak only as of the date on which they are made, are not guarantees of future performance, and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results could materially differ from what is expressed, implied or forecast in these forward-looking statements. Words such as “believe,” “will,” “plan,” “expect,” “intend,” “estimate,” “approximate,” and similar expressions may identify such forward-looking statements.
There have been no material changes in our risk factors from those reported at April 30, 2004 in our Annual Report on Form 10-K.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in our market risks from those reported at April 30, 2004 in our Annual Report on Form 10-K.
CONTROLS AND PROCEDURES
Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, such as this Form 10-Q, is recorded, processed, summarized and reported in accordance with the SEC’s rule. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer or persons performing similar functions, as appropriate, to allow timely decisions regarding disclosure.
Our Disclosure Controls were designed to provide reasonable assurance that the controls and procedures would meet their objectives. Our management, including the CEO and CFO, does not expect that our Disclosure Controls will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable assurance of achieving the designed control objectives and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple errors or mistakes. Additionally, controls can be circumvented by the individual acts of some persons, by collusions of two or more people, or by management override of the control. Because of the inherent limitations in a cost-effective, maturing control system, misstatements due to error or fraud may occur and not be detected.
As of October 31, 2004, we evaluated the effectiveness of the design and operation of our Disclosure Controls. The controls evaluation was done under the supervision and with the participation of management, including our CEO and CFO.
The evaluation of our Disclosure Controls included a review of the controls’ objectives and design, our implementation of the controls and the effect of the controls on the information generated for use in this Form 10-Q. In our Form 10-K for the year ended April 30, 2004, we reported a series of control weaknesses related to our corporate tax accounting function. These weaknesses related specifically to the reconciliation and level of detailed support of both current and deferred income tax accounts. We also determined an acceleration of taxable income was warranted in one of our segments, although there was no change to our total income tax provision. Upon identification of these control weaknesses,
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immediate corrective action was undertaken. Our efforts to strengthen financial and internal controls continue. We expect these efforts to be completed by the end of fiscal year 2005.
Based on this evaluation, other than the item described above, our CEO and CFO have concluded these controls are effective. There have been no significant changes in internal controls, or in other factors, which would significantly affect these controls subsequent to the date of evaluation.
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information below should be read in conjunction with the information included in note 11 to our condensed consolidated financial statements.
We reported in current reports on Form 8-K, previous quarterly reports on Form 10-Q and in our annual report on Form 10-K for the year ended April 30, 2004, certain events and information regarding lawsuits throughout the country regarding our refund anticipation loan programs (collectively, “RAL Cases”). The RAL Cases have involved a variety of legal theories asserted by plaintiffs. These theories include allegations that, among other things, disclosures in the RAL applications were inadequate, misleading and untimely, the RAL interest rates were usurious and unconscionable, we did not disclose that we would receive part of the finance charges paid by the customer for such loans, breach of state laws on credit service organizations, breach of contract, unjust enrichment, unfair and deceptive acts or practices, violations of the Racketeer Influenced and Corrupt Organizations (RICO) Act, violations of the Fair Debt Collection Practices Act and we owe and breached a fiduciary duty to our customers in connection with the RAL program.
The amounts claimed in the RAL Cases have been substantial in some instances. We have successfully defended against numerous RAL Cases, although several of the RAL Cases are still pending. Of these RAL Cases that are no longer pending, some were dismissed on our motions for dismissal or summary judgment and others were dismissed voluntarily by the plaintiffs after denial of class certification. Other cases were settled, with one settlement resulting in a pretax expense of $43.5 million in fiscal year 2003 (the “Texas RAL Settlement”).
We continue to believe we have meritorious defenses to the RAL Cases, and we intend to defend the remaining RAL Cases vigorously. There can be no assurances, however, as to the outcome of the pending RAL Cases individually or in the aggregate. Furthermore, there can be no assurances regarding the impact of the RAL Cases on our financial statements. We have accrued our best estimate of the probable loss related to the RAL Cases. The following is updated information regarding the pending RAL Cases in which developments occurred during or after the three months ended October 31, 2004:
Lynne A. Carnegie, et al. v. Household International, Inc., H&R Block, Inc., et al., (formerly Joel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., Block Financial Corporation, et al.) Case No. 98 C 2178, United States District Court for the Northern District of Illinois, Eastern Division, instituted on April 18, 1998. On April 15, 2003, the District Court judge declined to approve a $25.0 million settlement of this matter, finding that counsel for the settlement plaintiffs had been inadequate representatives of the plaintiff class and failed to sustain their burden of showing that the settlement was fair. The judge subsequently appointed new counsel for the plaintiffs who filed an amended complaint and a motion for partial summary judgment. On March 29, 2004, the court either dismissed or decertified all of the plaintiffs’ claims other than part of one count alleging violations of the racketeering and conspiracy provisions of the RICO Act. The United States Court of Appeals for the Seventh Circuit subsequently affirmed the trial court’s certification of a nationwide class on the RICO count. The case is scheduled to go to trial in March 2005. We intend to continue defending the case vigorously, but there are no assurances as to its outcome.
Joyce Green, et al. v. H&R Block, Inc., Block Financial Corporation, et al., Case No. 97195023, in the Circuit Court for Baltimore City, Maryland, instituted on July 14, 1997. Our Board of Directors approved a proposed settlement of the case on September 8, 2004. During the process of finalizing the settlement agreement, the parties were unable to reach agreement regarding certain settlement terms. We intend to continue defending the case vigorously, but there is no assurance as to its outcome.
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Deandra D. Cummins, et al. V. H&R Block, Inc., et al., Case No. 03-C-134 in the Circuit Court of Kanawha County, West Virginia. A class certification hearing commenced in October 2004 and was continued until December 22, 2004. A decision on class certification is expected in early 2005, and the case is scheduled to go to trial in October 2005.
Peace of Mind Litigation
Lorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Civil Action 2002L000004, in the Circuit Court of Madison County, Illinois, is a class action case filed on January 18, 2002, as to which the court granted plaintiffs’ first amended motion for class certification on August 27, 2003. Plaintiffs’ claims consist of five counts relating to the defendants’ Peace of Mind program under which the applicable tax return preparation subsidiary assumes liability for the cost of additional tax assessments attributable to tax return preparation error. The plaintiffs allege that defendants’ sale of its Peace of Mind guarantee constitutes statutory fraud by selling insurance without a license, an unfair trade practice, by omission and by “cramming” (i.e., charging customers for the guarantee even though they did not request it and/or did not want it), and constitutes a breach of fiduciary duty. In August 2003, the court certified the following plaintiff classes: (1) all persons who were charged a separate fee for Peace of Mind by “H&R Block” or a defendant H&R Block class member from January 1, 1997 to final judgment; (2) all persons who reside in certain class states and who were charged a separate fee for Peace of Mind by “H&R Block,” or a defendant H&R Block class member, and that was not licensed to sell insurance, from January 1, 1997 to final judgment; and (3) all persons who had an unsolicited charge for Peace of Mind posted to their bills by “H&R Block” or a defendant H&R Block class member from January 1, 1997, to final judgment. Among those excluded from the plaintiff classes are all persons who received the Peace of Mind guarantee through an H&R Block Premium office and all persons who reside in Texas and Alabama. The court also certified a defendant class consisting of any entity with the names “H&R Block” or “HRB” in its name, or otherwise affiliated or associated with H&R Block Tax Services, Inc., and which sold or sells the Peace of Mind product. The trial court subsequently denied the defendants’ motion asking the trial court to certify the class certification issues for interlocutory appeal. Discovery is proceeding.
There is one other putative class action pending against us in Texas that involves the Peace of Mind guarantee. This case is being tried before the same judge that presided over the Texas RAL Settlement and involves the same plaintiffs attorneys that are involved in the Marshall litigation in Illinois and substantially similar allegations. No class has been certified in this case.
We believe the claims in these Peace of Mind actions are without merit and we intend to defend them vigorously. However, there can be no assurances as to the outcome of these pending actions individually or in the aggregate, and there can be no assurances on the impact of these actions on our consolidated results of operations or financial position.
Other Claims and Litigation
As with other broker-dealers, HRBFA has been the subject of an investigation by the National Association of Securities Dealers, Inc. (NASD) regarding the market timing of mutual funds. The investigation concerns the trading activity by two former financial advisors, primarily on behalf of one of HRBFA’s clients. HRBFA has cooperated with the NASD and has had substantive settlement discussions. While these discussions have not concluded, we anticipate that the matter will be resolved in the near future, although we cannot provide assurance regarding the ultimate resolution of this matter, we believe the resolution will not have a material adverse effect on our operations, consolidated results of operations or financial position.
As reported in a current report on Form 8-K dated November 8, 2004, the NASD brought charges against HRBFA related to the sale by HRBFA of Enron debentures in 2001. A private civil action subsequently was filed against HRBFA concerning the matter raised in the NASD’s charges. We intend to defend the charges vigorously. There can be no assurances as to the outcome and resolution of this matter.
As part of an industry-wide review, the Internal Revenue Service (IRS) is investigating tax-planning strategies that certain RSM clients utilized during fiscal years 2000 through 2003. Specifically, the IRS is examining these strategies to determine whether RSM complied with tax shelter registration and listing regulations and whether such strategies were appropriate. If the IRS were to determine that these
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strategies were inappropriate, clients that utilized the strategies could face penalties and interest for underpayment of taxes and may attempt to seek recovery from RSM. There can be no assurances as to the outcome of this matter.
As reported in current report on Form 8-K dated December 12, 2003, the United States SEC informed outside counsel to the Company on December 11, 2003 that the Commission had issued a Formal Order of Investigation concerning our disclosures, in and before November 2002, regarding RAL litigation to which we were and are a party. There can be no assurances as to the outcome and resolution of this matter.
We have from time to time been party to claims and lawsuits not discussed herein arising out of our business operations. These claims and lawsuits include actions by individual plaintiffs, as well as cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. Some of these claims and lawsuits pertain to RALs and the Peace of Mind guarantee program. Others are claims and lawsuits that we consider to ordinary, routine litigation incidental to our business, including claims and lawsuits (“Other Claims”) concerning the Express IRA program and the preparation of customers’ income tax returns, the electronic filing of customers’ tax returns, the fees charged customers for various products and services, losses incurred by customers with respect to their investment accounts, relationships with franchisees, denials of mortgage loans, contested mortgage foreclosures, other aspects of the mortgage business, intellectual property disputes, and contract disputes. We believe we have meritorious defenses to each of the Other Claims, and we are defending, or intend to defend, them vigorously. While we cannot provide assurance that we will ultimately prevail in each instance, we believe the amount, if any, we are required to pay in the discharge of liabilities or settlements in these other matters will not have a material adverse effect on our consolidated results of operations or financial position.
ITEM 2. CHANGES IN SECURITIES AND USES OF PROCEEDS
A summary of our purchases of H&R Block common stock during the second quarter of fiscal year 2005 is as follows:
(shares in 000s)
Our Articles of Incorporation were amended on September 30, 2004 to increase the number of authorized shares of common stock, without par value, from 500,000,000 shares to 800,000,000 shares. The aggregate number of shares of all classes of stock that we now have authority to issue is 806,000,000, with 800,000,000 authorized shares of common stock and 6,000,000 authorized shares of a class designated preferred stock, without par value. The amendment to the Articles of Incorporation was approved by our shareholders at the annual meeting of shareholders held on September 8, 2004. The Certificate of Amendment is filed as Exhibit 3.1 to this Form 10-Q, and the Restated Articles of Incorporation, incorporating all amendments thereto, are filed as Exhibit 3.2 to this Form 10-Q.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSThe annual meeting of shareholders of the registrant was held on September 8, 2004. At such meeting, three Class III directors were elected to serve three-year terms. In addition, the proposals set forth below were submitted to a vote of shareholders. With respect to the election of directors and the adoption of each
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proposal, the number of votes cast for, against or withheld, the number of abstentions, and the number of no votes (if applicable) were as follows:
Approval of an Amendment to the Company’s Articles of Incorporation to increase the number of shares of Common Stock from 500,000,000 to 800,000,000
Approval of an Amendment to the 1989 Stock Option Plan for Outside Directors to extend the plan for five years, such that it will terminate, unless further extended, on December 5, 2009
Approval of an Amendment to the 1999 Stock Option Plan for Seasonal Employees to (i) extend the Plan for two years, such that it will terminate, unless further extended, on December 31, 2006 and (ii) increase the aggregate number of authorized shares of Common Stock issuable under the Plan from 20,000,000 to 23,000,000
Ratification of the Appointment of KPMG LLP as the Registrant’s Independent Accountants for the year ended April 30, 2005
At the close of business on June 30, 2004, the record date for the annual meeting of shareholders, there were 167,770,955 shares of Common Stock of the registrant outstanding and entitled to vote at the meeting. There were 146,092,989 shares represented at the annual meeting of shareholders held on September 8, 2004.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
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b) Reports on Form 8-K
The registrant filed current reports on Form 8-K and Form 8-K/A, each dated August 24, 2004, reporting under Item 2.02 thereof its issuance of a press release announcing the results of operations for its first quarter ending July 31, 2004.
The registrant filed current reports on Form 8-K and Form 8-K/A, each dated September 9, 2004, reporting under Item 1.01 and/or Item 5.02 thereof its appointment of a Chief Financial Officer.
The registrant filed a current report on Form 8-K dated October 18, 2004, reporting under Items 5.02 and 9.01 thereof its issuance of a press release announcing the election of a new member to its Board of Directors.
The registrant filed a current report on Form 8-K dated October 21, 2004, reporting under Items 1.01, 8.01 and 9.01 thereof its entry into an underwriting agreement in connection with its debt offering.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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