SECURITIES AND EXCHANGE COMMISSION
Commission file number 1-6089
H&R BLOCK, INC.
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 þ No o
The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on August 29, 2003 was 178,274,715 shares.
TABLE OF CONTENTS
H&R BLOCK, INC.CONDENSED CONSOLIDATED BALANCE SHEETSAmounts in thousands, except share amounts
See Notes to Condensed Consolidated Financial Statements
-1-
H&R BLOCK, INC.CONDENSED CONSOLIDATED INCOME STATEMENTSUnaudited, amounts in thousands, except per share amounts
-2-
H&R BLOCK, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSUnaudited, amounts in thousands
-3-
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
-4-
-5-
-6-
-7-
-8-
-9-
-10-
-11-
-12-
-13-
-14-
-15-
-16-
-17-
-18-
-19-
Condensed Consolidating Income Statements
-20-
Condensed Consolidating Balance Sheets
-21-
Condensed Consolidating Statements of Cash Flows
-22-
-23-
MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
RESULTS OF OPERATIONS
H&R Block, Inc. (the Company) is a diversified company with subsidiaries primarily engaged in the business of providing financial services including tax services, investment and mortgage products and services, and accounting and consulting services. For nearly 50 years, the Company has been developing relationships with millions of tax clients and its strategy is to expand on these relationships.
H&R Block’s Mission:
To help our clients achieve their financial objectivesby serving as their tax and financial partner.
H&R Block’s Vision:
To be the world’s leading provider of financial servicesthrough tax and accounting based advisory relationships.
Key to achieving the Company’s mission and vision is enhancing client experiences through consistent delivery of valuable services and advice. The Company believes offering advice facilitates a financial partnership and increases client satisfaction and retention. New products and services are continually introduced to bring additional value to the overall experience and allow clients to reach their financial objectives. Operating in multiple lines of business allows H&R Block to serve the changing financial needs of all its customers. The Company carries out its mission and vision through the following reportable operating segments:
U.S. Tax Operations: This segment primarily consists of the Company’s income tax preparation businesses. Retail tax offices served 16.5 million taxpayers in fiscal year 2003 — more than any other personal tax services company. This segment also served 2.1 million clients through TaxCut® tax preparation software (includes only federal e-filings) and online tax preparation in fiscal year 2003. By offering professional and do-it-yourself tax preparation options, the Company can serve its clients how they choose to be served.
Mortgage Operations: This segment is primarily engaged in the origination of non-prime mortgage loans, the sale and securitization of mortgage assets (which includes mortgage loans and residual interests), and the servicing of non-prime loans. A key focus of Mortgage Operations is to optimize cash flows from its operations. The Company believes offering mortgage products to other segments’ clients results in added value to the total client experience.
Business Services: This segment is engaged in providing accounting, tax, consulting, payroll, employee benefits and capital markets services to business clients and tax, financial and estate planning, wealth management and insurance services to individuals. The Company continues to focus on establishing core service relationships with middle-market clients by adding non-traditional business and personal services to enhance these client relationships. In doing so, the
-24-
Company intends to develop Business Services as a leading provider of middle-market professional services.
Investment Services: This segment is primarily engaged in offering investment services and securities products. Investment Services also offers these services and products to U.S. Tax and Mortgage Operations clients, bringing additional value to the overall client experience.
International Tax Operations: This segment is primarily engaged in providing local tax return preparation, filing and related services in Canada, Australia and the United Kingdom. In addition, International Tax Operations includes Overseas operations, which consists of company-owned and franchise offices preparing tax returns for U.S. citizens living abroad.
The analysis that follows should be read in conjunction with the tables below and the condensed consolidated income statements found on page 2.
Consolidated H&R Block, Inc.
Consolidated H&R Block, Inc. – Three-Month Results(in 000s, except per share amounts)
Overview
A summary of the Company’s results for the three months ended July 31, 2003 is as follows:
-25-
U.S. Tax Operations
This segment is primarily engaged in providing tax return preparation, filing and related services in the United States. Segment revenues include fees earned for tax-related services performed at company-owned tax offices, royalties from franchise offices, sales of tax preparation and other software, fees from online tax preparation, and payments related to refund anticipation loan (RAL) participations.
TaxCut® from H&R Block enables do-it-yourself users to prepare their federal and state tax returns easily and accurately. Several versions of the software are available to suit the needs of individual users, including TaxCut Standard, TaxCut Deluxe (includes free state and electronic filing), TaxCut Platinum for more complex returns and TaxCut Home & Business for small business owners. Other personal productivity software packages are also offered, including H&R Block Deduction Pro, WillPower and Home & Business Attorney.
Clients also have the option of online do-it-yourself tax preparation, online professional tax review, online tax advice and online tax preparation through a tax professional (whereby the client completes an online tax organizer and sends it to a tax professional for preparation) through the hrblock.com website. The Company participates in the Free File Alliance, formed in fiscal year 2003. This alliance was created by the industry and the Internal Revenue Service (IRS), and allows qualified lower-income filers to prepare and file their federal return online at no charge.
-26-
U.S. Tax Operations – Three-Month Results(in 000s)
Three months ended July 31, 2003 compared to July 31, 2002
U.S. Tax Operations’ revenues increased $6.4 million, or 27.4%, for the three months ended July 31, 2003, compared to the three months ended July 31, 2002.
Tax preparation and related fees increased $1.1 million, or 10.0%, for the three months ended July 31, 2003. This increase is primarily due to an 8.5% increase in the average charge, net of discounts, offset by a 2.7% decrease in tax returns prepared. The net average charge increased to $156.88 in the current quarter compared to $144.62 last year. Average charge is calculated as tax preparation and filing fees, less discounts if applicable, divided by the number of clients served. Tax returns prepared in company-owned offices during the current quarter were 87 thousand, compared to 89 thousand in the prior year.
Tax returns prepared at franchise offices increased by 2.6%, resulting in an increase in royalty income of 13.2%.
-27-
During fiscal year 2003, the Company entered into an agreement with Household Tax Masters, Inc. (Household), whereby the Company waived its right to purchase any participation interests in and receive license fees for RALs during the period January 1 through April 30, 2003. In consideration for waiving these rights the Company received a series of payments from Household in fiscal year 2003, subject to certain adjustments in fiscal year 2004 based on delinquency rates. At July 31, 2003 the Company recorded additional revenues of $4.1 million based on actual delinquency rates through July 31, 2003. The waiver agreement with Household was a one-year agreement. The final payment is expected to be received in January 2004, based on delinquency rates as of December 31, 2003.
Other revenues for the three months ended July 31, 2003 increased $1.7 million, or 16.7%, principally due to revenues of $8.7 million related to Peace of Mind guarantees.
Total expenses for the three months ended July 31, 2003 were $124.4 million, up $7.1 million, or 6.0%, from the prior year. Occupancy and equipment costs increased $3.1 million due primarily to a 4.9% increase in the number of offices under lease and a 5.6% increase in average rents paid. Depreciation and amortization expenses increased in conjunction with additional equipment purchased during the preceding year. Other expenses in the current quarter increased $3.6 million over last year. The increase was primarily due to $3.1 million of interest accretion related to a legal settlement. Information technology expenses increased $4.0 million, or 25.2%, for the quarter ended July 31, 2003, primarily due to additional technology projects initiated. Offsetting these increases, compensation and benefits declined $2.2 million, or 8.5%, due to better management of off-season labor costs.
The pretax loss of $94.7 million for the three months ended July 31, 2003, represents a 0.7% increase over the prior year loss of $94.0 million.
Due to the seasonal nature of this segment’s business, operating results for the three months ended July 31, 2003 are not comparable to the three months ended April 30, 2003 and are not indicative of the expected results for the entire fiscal year.
Mortgage Operations
This segment is primarily engaged in the origination of non-prime mortgage loans, sales and securitizations of mortgage assets and servicing of non-prime loans. Revenues consist of proceeds from sales and securitizations of loans and related assets, accretion on residual interests, loan servicing fees and interest received on loans.
Substantially all non-prime mortgage loans originated are sold daily to qualifying special purpose entities (Trusts). The Company removes the mortgage loans from its balance sheet and records the gain on the sale, cash and a receivable which represents the ultimate expected outcome from the disposition of the loans by the Trusts. See discussion of an exposure draft in note 13 related to the Company’s off-balance sheet arrangements. The Trusts, as directed by the third-party beneficial interest holders, either sell the loans directly to third-party investors or back to the Company to pool the loans for securitization, depending on market conditions. In a securitization transaction, the Trusts transfer the loans to a special purpose entity, which is a consolidated
-28-
subsidiary of the Company and the Company simultaneously transfers the loans and its receivable, and the right to receive all payments on the loans, to a securitization trust. The securitization trust meets the definition of a qualifying special purpose entity (QSPE) and is therefore not consolidated by the Company. The securitization trust issues bonds, which are supported by cash flows from the pooled loans, to third-party investors. The Company retains an interest in the loans in the form of a residual interest (including overcollateralization (OC) accounts and uncertificated interests) and usually assumes first risk of loss for credit losses in the loan pool. As the cash flows of the underlying loans and market conditions change, the value of the Company’s residual interests may also change, resulting in either additional unrealized gains or impairment of the residual interests.
To accelerate cash flows from its residual interests, the Company securitizes the majority of its residual interests in net interest margin (NIM) transactions. In a NIM transaction, residual interests are transferred to another QSPE (NIM trust), which then issues bonds to third-party investors. Proceeds from the bonds are returned to the Company as payment for the residual interests. The bonds are secured by pooled residual interests and are obligations of the NIM trust. The Company retains a subordinated interest in the NIM trust, and receives cash flows on its residual interest generally after the bonds issued to the third-party investors are paid in full. Residual interests retained from NIM securitizations may also be bundled and sold in a subsequent securitization.
Substantially all non-prime loans originated and subsequently sold or securitized are transferred with servicing rights retained. Servicing activities include processing of mortgage loan payments and the administration of mortgage loans, with loan servicing fees received monthly over the life of the mortgage loans. The Company has traditionally received a servicing fee of 50 basis points per annum on the outstanding principal balance of loans sold or securitized, as well as the right to receive certain ancillary income including, but not limited to, late fees and prepayment penalties. In recent transactions, step-servicing fee structures have been implemented. The purpose of step-servicing is to better match the stream of incoming servicing revenues against the related servicing expenses. Generally, the cost to service a pool of loans is lower immediately after origination and increases as the related loan pool ages. Recent step-servicing fee structures provide the company with a servicing fee of 30 basis points per annum for the first 10 months of servicing, 40 basis points per annum for the next 20 months of servicing, 65 basis points per annum for the next 18 months and 80 basis points for the remainder of the servicing term.
Prime mortgage loans are sold in whole loan sales, servicing rights released, to third-party buyers.
-29-
Mortgage Operations – Three-Month Operating Statistics
-30-
Mortgage Operations – Three-Month Operating Results(in 000s)
Mortgage Operations’ revenues increased $52.6 million, or 21.0%, for the three months ended July 31, 2003 compared to the prior year quarter. Revenue increased primarily as a result of higher production volumes.
The following table summarizes the key drivers of gains on sales of mortgage loans:
-31-
Gains on sales of mortgage loans and related assets increased $37.9 million for the three months ended July 31, 2003. The increase over last year is a result of a significant increase in loan origination volume, partially offset by a decrease in loan sale execution pricing. During the first quarter, the Company originated $5.3 billion in mortgage loans compared to $3.4 billion last year, an increase of 57.4%. The execution price on mortgage loans originated and sold decreased to 4.42% for the current quarter compared to 4.88% last year, primarily as a result of a decrease in the average interest rate during the period.
Impairments of residual interests in securitizations of $10.7 million were recognized in the current period, due to a decline in value of older residuals based on loan performance. Impairments of residuals for the three months ended July 31, 2002 totaled $20.4 million.
The following table summarizes the key drivers of loan servicing revenues:
Loan servicing revenues increased $9.4 million, or 24.0%, this year. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the three-month period ended July 31, 2003 increased $6.9 billion, or 26.8%, to $32.8 billion.
Total accretion of residual interests of $34.1 million for the three months ended July 31, 2003 represents a decrease of $4.7 million from prior year accretion of $38.8 million. This decline is due to a lower average balance of related residuals, resulting from the sale of previously securitized residual interests (NIM residuals) during the third quarter of fiscal year 2003.
During the first quarter of fiscal year 2004, the Company’s residual interests continued to perform better than expected in the Company’s valuation models, primarily due to sustained low interest rates and more favorable trends in prepayment and loss rates. As a result of these items, the Company recorded pretax mark-to-market write-up adjustments, which increased the fair value of its residual interests $57.5 million during the quarter. These write-ups were recorded, net of write-downs of $3.9 million and deferred taxes of $20.4 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 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. Additionally, sales of NIM residual interests would result in decreases to accretion income in future periods.
Interest income increased slightly for the quarter ended July 31, 2003, due to the average balance on loans held by the Trusts increasing to $2.0 billion from $1.4 billion in the prior-year quarter. This increase was offset by lower interest margin earned. Interest margin is the difference
-32-
between the rate on the underlying loans and the financing costs of the Trusts. The interest margin decreased to 5.51% during the three months ended July 31, 2003, from 6.40% a year ago.
Total expenses for the three months ended July 31, 2003, increased $35.8 million, or 34.7% over the year-ago quarter. This increase is primarily due to $12.5 million in increased compensation and benefits as a result a 22.2% increase in employees needed to support higher loan production volumes. Servicing and processing expenses increased by $10.2 million as a result of a higher average servicing portfolio during the three months ended July 31, 2003. Occupancy and equipment charges increased $4.0 million due to additional branch offices opened in the prior fiscal year, the opening of a second servicing center and additional administrative office space. Bad debt expense increased $3.7 million, or 63.4%, primarily as a result of the 57.4% increase in loan production volumes. Other expenses increased by $5.4 million to $27.3 million for the current quarter, primarily due to $2.4 million in increased marketing expenses.
Pretax income increased $16.7 million to $163.8 million for the three months ended July 31, 2003.
Market interest rates have recently begun to increase after a sustained period of declining rates. In a rising interest rate environment the Company expects its margins will narrow from their historically high levels. As such, growth in pretax income for the mortgage operations segment is expected to be more moderate or perhaps decline from results (excluding a $130.9 million gain on sale of NIM residual interests) for the fiscal year ended April 30, 2003.
Three months ended July 31, 2003 compared to April 30, 2003
Mortgage Operations’ revenues increased $24.4 million, or 8.7%, for the three months ended July 31, 2003, compared to the preceding quarter.
-33-
Gains on sales of mortgage loans and related assets for both wholesale and retail increased $2.3 million to $203.4 million for the current quarter. This increase from the preceding quarter is primarily a result of a 10.9% increase in loans originated, and to a lesser extent, an increase in execution price on loan sales. The execution price on loan sales for the quarter increased to 4.42% from 4.37% for the three months ended April 30, 2003.
Impairments of residual interests in securitizations of $10.7 million were recognized during the first quarter, due to a decline in value of older residuals based on loan performance. Impairments of residuals for the three months ended April 30, 2003 totaled $28.5 million.
Loan servicing revenues increased $3.6 million, or 8.1%, compared to the fourth quarter of fiscal year 2003. The increase reflects a higher loan-servicing portfolio. The average servicing portfolio for the three months ended July 31, 2003 increased $2.8 billion, or 9.3%, to $32.8 billion.
Accretion of residual interests of $34.1 million represents an increase of 6.4% from the preceding quarter accretion of $32.0 million, due to write-ups taken during the fourth quarter of fiscal year 2003.
Total expenses decreased $8.6 million, or 5.8%, primarily due to a decline in compensation and benefit costs. The decline is the result of a higher profit sharing accrual in the fourth quarter of fiscal year 2003 associated with the segment’s performance in the previous year.
Pretax income increased $33.0 million, or 25.2%, for the three months ended July 31, 2003 compared to the preceding quarter.
Business Services
This segment is engaged in providing accounting, tax, consulting, payroll, employee benefits and capital markets services to business clients and tax, financial and estate planning, wealth management and insurance services to individuals. Business Services provides accounting, payroll and human resources services to McGladrey & Pullen LLP (M&P) in exchange for a management fee. The Company also has commitments to fund M&P’s operations.
-34-
A substantial portion of Business Services’ business is generated by one-time projects or extended services. The uncertainty surrounding the current business environment has caused clients to delay making strategic decisions and spending money on discretionary projects. This uncertainty has adversely affected growth in consulting services and, to a lesser extent, tax services.
Business Services – Three-Month Results(in 000s)
Business Services’ revenues for the three months ended July 31, 2003 increased $3.2 million, or 3.3%, from the prior year. This increase was primarily due to a $6.7 million increase in capital markets revenues, resulting from a higher number of business valuation projects delivered. This increase was partially offset by a decline in traditional accounting revenues. The current economic recession and a continuing cautious business environment have contributed to weakness in the segment’s traditional accounting and business consulting services.
Total expenses increased $5.6 million, or 5.6%, for the three months ended July 31, 2003 compared to the prior year. Occupancy and equipment costs increased $1.6 million and compensation and benefits costs increased $1.2 million, primarily as a result of the payroll processing and capital markets businesses. Additionally, costs for seminars and workshops increased $1.0 million, as comparable costs were incurred during the second quarter in the prior year.
The pretax loss for the three months ended July 31, 2003 was $6.7 million compared to a loss of $4.3 million in the prior year.
35
Investment Services
This segment is primarily engaged in offering investment services and securities products through H&R Block Financial Advisors, Inc. (HRBFA), a full-service securities broker-dealer. Products and services offered to Investment Services’ customers include: equities, annuities, fixed income products, mutual funds, margin accounts, money market funds with sweep provisions for settlement of customer transactions, checking privileges, account access/review via the internet, online trading, fee-based accounts, individual retirement accounts, dividend reinvestment and option accounts, equity research and focus lists, model portfolios, asset allocation strategies, economic commentaries and other investment tools and information. In addition, clients of the Company’s U.S. Tax Operations segment are given the opportunity to open an Express IRA through HRBFA as a part of the income tax return preparation process.
Key to the future success of the Investment Services segment is retention of its financial advisors and recruitment of new advisors. One of the Company’s key initiatives is to build revenues through the addition of experienced financial advisors. Forty new advisors were recruited during the first quarter, which was offset by attrition of primarily less experienced advisors. The retention and recruitment of experienced advisors will continue to be a key initiative during the remainder of fiscal year 2004.
36
Investment Services – Three-Month Operating Statistics
37
Investment Services – Three-Month Operating Results(in 000s)
Investment Services’ revenues, net of interest expense, for the three months ended July 31, 2003 declined $0.6 million, or 1.0%, compared to the prior year. The decrease is primarily due to lower net interest revenue.
Transactional revenue, which is based on transaction or trade quantities, declined $3.0 million, or 10.3%, from the prior year due to the decline in trading activity. Annuitized revenues, which are based on customer assets rather than transactions, increased $3.1 million, or 33.6%, due to additional underwriting fees recognized in the current quarter and increased sales of annuities and mutual funds.
Margin interest revenue declined 23.8% from the prior year to $8.5 million, which is primarily a result of a 20.6% decline in margin balances and, to a lesser extent, lower interest rates. Margin balances have declined from an average of $721.0 million for the three months ended July 31, 2002 to $501.1 million in the current period, due to weak investor confidence. Accordingly,
38
interest expense for the first quarter of fiscal year 2004 declined 63.9% to $0.6 million compared to $1.7 million in the first quarter of fiscal year 2003.
Total expenses decreased $19.6 million, or 21.9%, to $70.1 million primarily as a result of the $18.0 million goodwill impairment charge recorded in the prior year. Other expenses decreased primarily as a result of consulting fees incurred in the prior year related to the conversion to a new back-office system.
The pretax loss for Investment Services for the first quarter of fiscal year 2004 was $13.8 million compared to the prior year loss of $32.8 million.
Investment Services’ revenues, net of interest expense, for the three months ended July 31, 2003 improved $12.9 million, or 29.8%, compared to the preceding quarter.
Production revenues increased $9.2 million, or 31.2%, primarily due to increased trading activity in the current quarter. Underwriting revenues, which are included in annuitized revenues, also increased $1.9 million over the preceding quarter. These increases are primarily a result of poor production in the fourth quarter of fiscal year 2003 due to economic conditions and equity market trends.
Margin interest revenue rose $1.1 million, or 14.4%, to $8.5 million for the quarter ended July 31, 2003. The increase in margin interest revenue is due to six additional days in the current quarter and higher average yield on margin balances.
Total expenses decreased $9.1 million from the preceding quarter. The $6.9 million decrease in other expenses is primarily due to a decline of $1.2 million in purchased services and a $1.1 million decline in seminars and workshops, both relating to higher costs in the preceding quarter from the development of training programs to support the broader sales approach. In addition, consulting fees declined $1.2 million and marketing costs decreased $0.9 million.
The pretax loss for the Investment Services segment was $13.8 million, 61.6% better than the fourth quarter of fiscal year 2003.
International Tax Operations
This segment is primarily engaged in providing local tax return preparation, filing and related services in Canada, Australia and the United Kingdom. In addition, International Tax Operations includes Overseas operations, which consists of company-owned and franchise offices in eight countries that prepare U.S. tax returns for U.S. citizens living abroad. This segment served 2.3 million taxpayers in fiscal year 2003.
Tax-related service revenues include fees from company-owned tax offices and royalties from franchise offices. The Canadian tax season is from January to April, the Australian tax season is from July to October and the United Kingdom’s tax season is from August to March.
39
Operations in this segment of the Company are transacted in the local currencies of the countries in which it operates, therefore the results can be affected by the translation into U.S. dollars. The weakening of the U.S. dollar during the quarter had the impact of increasing reported revenues and losses.
International Tax Operations – Three-Month Results(in 000s)
International Tax Operations’ revenues for the three months ended July 31, 2003 increased $1.2 million, or 27.5%, compared to the three months ended July 31, 2002. This improvement is primarily due to results in Canada, where tax returns prepared in the current quarter increased 4.2% compared to the prior year and the average charge per return increased 7.2%. Australian revenues also improved, due to increases of 17.8% and 1.8% in the number of off-season returns and average charge per return, respectively.
The pretax loss of $6.4 million for the quarter ended July 31, 2003, was nearly flat compared to the loss recorded in the first quarter last year. While results in Canada improved as a result of cost containment measures, results in Australia declined due to increased off-season costs and unfavorable exchange rates.
40
Corporate Operations
This segment consists primarily of corporate support departments, which provide services to the Company’s operating segments. These support departments consist of marketing, information technology, facilities, human resources, executive, legal, finance, government relations and corporate communications. These support department costs are largely allocated to the Company’s operating segments. The Company’s captive insurance and franchise financing subsidiaries are also included within this segment.
Corporate Operations – Three-Month Results(in 000s)
Revenues increased $1.8 million as a result of a write-down of investments at the Company’s captive insurance subsidiary in the prior year.
Corporate expenses remained relatively flat over the prior year. The decrease in interest expense on acquisition debt is attributable to lower financing costs and a $39.8 million payment on acquisition debt in August 2002. Other expenses increased as a result of additional consulting fees of $1.2 million related to long-term space planning, coupled with additional increases in insurance costs and audit and legal fees.
41
Information technology department expenses increased $4.3 million, or 22.6%, primarily due to an increase in headcount and related facilities. Marketing department expenses decreased primarily due to the shifting of certain projects into the second quarter of fiscal year 2004.
The pretax loss was $25.0 million, compared with last year’s first quarter loss of $25.4 million.
Due to the nature of this segment, the three months ended July 31, 2003 are not comparable to the three months ended April 30, 2003 and are not indicative of the expected results for the entire fiscal year.
42
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.
The Company’s liquidity needs are met primarily through a combination of operating cash flows, commercial paper (CP) issuance and off-balance sheet financing arrangements.
OPERATING CASH FLOWS & LIQUIDITY BY SEGMENT
Operating cash requirements totaled $107.9 million and $181.3 million for the three months ended July 31, 2003 and 2002, respectively. A condensed consolidating statement of cash flows by segment for the three months ended July 31, 2003 follows. Generally, interest is not charged on intercompany activities between segments.
Net intercompany activities are excluded from the investing and financing activities within the segment cash flows. The Company believes that by excluding the intercompany activities, the cash flows by segment more clearly depicts the cash generated and used by each segment. Had the 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.
U.S. Tax Operations: U.S. Tax Operations has historically been the largest provider of annual operating cash flows to the Company. This segment generally operates at a loss during the first two quarters of the fiscal year due to off-season costs and preparation activities for the upcoming tax season. The seasonal nature of U.S. Tax Operations generally results in a large positive operating cash flow in the fourth quarter. U.S. Tax Operations had total cash requirements of $158.9 million for the quarter ended July 31, 2003.
Mortgage Operations: This segment generates cash as a result of loan sales and securitizations, NIM transactions, sales of NIM residual interests and as its residual interests mature. Mortgage Operations generated $106.6 million in cash from operating activities primarily from the sale and securitization of mortgage loans. This segment also generated $23.2 million in cash from investing activities primarily from cash received on residual interests.
Gains on sales of mortgage loans and related assets totaled $192.6 million, of which 107% was received as cash. The cash was recorded as either operating or investing activities, depending on the asset sold.
43
Gains on sales of mortgage assets consist of the following:
Cash received on residual interests in securitizations totaled $27,502 and $41,309 for the three months ended July 31, 2003 and 2002, respectively.
The mortgage segment regularly sells loans as a source of liquidity for its prime and non-prime mortgages. Whole loan sales to the Trusts through July 31, 2003 were $5.3 billion compared with $4.0 billion for the same period in fiscal year 2003. Additionally, Block Financial Corporation (BFC) provides the mortgage segment a $150 million line of credit for working capital needs.
In order to finance its prime originations, the Company utilizes a warehouse facility with current capacity up to $100 million. This facility bears interest at one-month LIBOR plus 54 to 140 basis points. This annual facility is currently in the final stage of renegotiation, during which time the original maturity has been extended on a month-to-month basis. Under the terms of the renewed facility, the capacity will be reduced to $50 million and the facility will bear interest at one-month LIBOR plus 64 to 175 basis points. All new terms have been agreed to in principle and, as such, the Company began operating under the new terms beginning August 1, 2003. As of July 31, 2003, the balance outstanding under this facility was $16.7 million and is included in accounts payable, accrued expenses and other in the condensed consolidated balance sheets.
Management believes the sources of liquidity available to the Mortgage Operations segment are predictable and sufficient for its needs. Risks to the stability of these sources include external events impacting the asset-backed securities market. The liquidity available from the NIM transactions is also subject to external events impacting this market. These external events include, but are not limited to, adverse changes in the perception of the non-prime industry or in the regulation of non-prime lending and, to a lesser degree, reduction in the availability of third parties that provide credit enhancement. Performance of the securitizations will also impact the segment’s future participation in these markets. The three warehouse facilities used by the Trusts are subject to annual renewal, each at a different time during the year, in April, October and December and any of the above events could lead to difficulty in renewing the lines. These risks
44
are mitigated by the availability of whole loan sales and financing provided by the Company, and to a lesser extent, by staggered renewal dates related to these lines.
Business Services: Business Services funding requirements are largely related to working capital needs. Funding is available from the Company sufficient to cover these needs. This segment generated $14.1 million in cash from operating activities primarily related to the collections of receivables in the first quarter of fiscal year 2004.
Investment Services: Investment Services used $46.8 million in cash from operating activities during the quarter.
Investment Services, through HRBFA, is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers. HRBFA is required to maintain minimum net capital as defined under Rule 15c3-1 of the Securities Exchange Act of 1934 and complies with the alternative capital requirement, which requires a broker-dealer to maintain net capital equal to the greater of $1 million or 2% of the combined aggregate debit balances arising from customer transactions. The net capital rule also provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would be less than the greater of 5% of combined aggregate debit items or $1 million. As of July 31, 2003, HRBFA’s net capital of $118.4 million, which was 20.3% of aggregate debit items, exceeded its minimum required net capital of $11.7 million by $106.7 million.
To manage short-term liquidity, HRBFA maintains a $300 million unsecured credit facility with BFC, its indirect corporate parent. Additionally, HRBFA maintains a $125 million line of credit with a financial institution. As of July 31, 2003 there were no outstanding balances on these facilities.
Liquidity needs relating to client trading and margin-borrowing activities are met primarily through cash balances in client brokerage accounts and working capital. Management believes 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.
Securities borrowed and securities loaned transactions are generally reported as collateralized financings. These transactions require the Company to deposit cash and/or collateral with the lender. Securities loaned consist of securities owned by customers, which were purchased on margin. When loaning securities, the Company receives cash collateral approximately equal to the value of the securities loaned. The amount of cash collateral is adjusted, as required, for market fluctuations in the value of the securities loaned. Interest rates paid on the cash collateral fluctuate as short-term interest rates change.
To satisfy the margin deposit requirement of client option transactions with the Options Clearing Corporation (OCC), Investment Services pledges customers’ margined securities. Pledged securities as of July 31, 2003 totaled $53.9 million, an excess of $3.0 million over the margin requirement.
45
Management believes 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.
International Tax Operations: International Tax Operations provided $11.7 million in operating activities during the quarter primarily from collections of receivables from Revenue Canada related to its discounted return program.
International Tax Operations are generally self-funded. Cash balances are held in Canada, Australia and the United Kingdom independently in local currencies. H&R Block Canada has a commercial paper program up to $125 million (Canadian). At July 31, 2003, there was no commercial paper outstanding.
CAPITAL RESOURCES
Cash used in operating activities totaled $107.9 million for the three months ended July 31, 2003, compared with $181.3 million for the three months ended July 31, 2002.
Cash expenditures during the three months ended July 31, 2003 relating to investing and financing activities include the purchase of property and equipment ($12.7 million), payment of dividends ($32.4 million) and the acquisition of treasury shares ($83.6 million).
Cash and cash equivalents — restricted totaled $528.3 million at July 31, 2003. HRBFA held $506.8 million of this total segregated in a special reserve account for the exclusive benefit of customers pursuant to Rule 15c3-3 of the Securities Exchange Act of 1934. Restricted cash held by Mortgage Operations totaled $6.2 million at July 31, 2003 as a result of cash held for outstanding commitments to fund mortgage loans. Restricted cash of $15.2 million at July 31, 2003 held by Business Services is related to funds held to pay payroll taxes on behalf of its clients.
Working capital decreased to $781.0 million at July 31, 2003 from $850.2 million at April 30, 2003. A large portion of tax return preparation occurs in the fourth quarter and has the effect of increasing certain assets and liabilities during the fourth quarter, including cash and cash equivalents, receivables, accrued salaries, wages and payroll taxes and accrued taxes on income.
On September 12, 2001, the Company’s Board of Directors authorized the repurchase of 15 million shares of common stock. On June 11, 2003 the Company’s Board of Directors approved an authorization to repurchase up to 20 million additional shares of its common stock. During the first quarter of fiscal year 2004, the Company repurchased 1.9 million shares pursuant to these authorizations at an aggregate price of $82.8 million, or an average price of $43.82 per share. There are approximately 20.0 million shares remaining under these authorizations at July 31, 2003. The Company plans to continue to purchase its shares on the open market in accordance with this authorization, subject to various factors including the price of the stock, the ability to maintain progress toward a capital structure that will support a single A rating, the
46
availability of excess cash, the ability to maintain liquidity and financial flexibility, compliance with securities laws and other investment opportunities available.
OFF-BALANCE SHEET FINANCING ARRANGEMENTS
The Company has commitments to fund mortgage loans in its pipeline of $2.9 billion at July 31, 2003, subject to contract verification. External market forces impact the probability of loan commitments being closed, and therefore, total commitments outstanding do not necessarily represent future cash requirements. If the loan commitments are exercised, they will be funded through the Company’s off-balance sheet arrangements.
For the three months ended July 31, 2003, the final disposition of loans was 43% securitizations and 57% third-party whole loan sales. For the three months ended July 31, 2002, the final disposition of loans was 62% securitizations and 38% third-party whole loan sales.
In August 2003, the Company’s warehouse facilities utilized by the Trusts were increased to $5.0 billion. The additional $1.0 billion facility expires in August 2004 and bears interest at one-month LIBOR plus 50 to 60 basis points. This facility is subject to similar performance triggers, limits and financial covenants as the other facilities.
The Financial Accounting Standards Board (FASB) has issued an exposure draft, “Qualifying Special Purpose Entities and Isolation of Transferred Assets, an Amendment of FASB Statement No. 140.” The purpose of the proposal is to provide more specific guidance on the accounting for transfers of financial assets to a QSPE. If enacted, the exposure draft would be effective as of January 1, 2004.
Provisions in the exposure draft may require the Company to consolidate its current QSPEs (the Trusts) established in its Mortgage Operations segment. As of July 31, 2003, the Trusts had assets and liabilities of $1.8 billion. If necessary, the Company may be able to modify its current structure in a manner that would allow the Trusts to retain QSPE status and the off-balance sheet treatment. The provisions of the exposure draft are subject to FASB due process and subject to change. The Company will continue to monitor the status of the exposure draft, and consider changes to current structures to comply with the proposed rules.
There have been no other material changes in the Company’s off-balance sheet financing arrangements from those reported at April 30, 2003 in the Company’s Annual Report on Form 10-K.
COMMERCIAL PAPER ISSUANCE
The Company participates in the United States and Canadian commercial paper markets to meet daily cash needs. Commercial paper is issued by BFC and H&R Block Canada, Inc., wholly owned subsidiaries of the Company.
The Company incurs short-term borrowings throughout the year primarily to fund seasonal working capital needs, dividend payments and purchases of treasury stock. Because of the
47
seasonality of its businesses, the Company has historically had short-term borrowings throughout the year. There were no short-term borrowings at July 31, 2003, compared with $156.5 million at July 31, 2002.
U.S. commercial paper issuances are supported by an unsecured committed line of credit (CLOC) from a consortium of twenty-two banks. The $2.0 billion CLOC is subject to annual renewal in October 2003 and has a one-year term-out provision with a maturity date of October 22, 2004. This line is subject to various affirmative and negative covenants, including a minimum net worth covenant. The CLOC was undrawn at July 31, 2003.
Subsequent to July 31, 2003, the Company renegotiated its CLOC to include a working capital line. The new CLOC is from a consortium of twenty-four banks. The $2.0 billion CLOC is subject to annual renewal in August 2004 and has a one-year term-out provision with a maturity date in August 2005. This line is subject to various affirmative and negative covenants. This CLOC includes $1.5 billion for CP back-up and general corporate purposes and $500 million for working capital use, general corporate purposes and CP back-up.
The Canadian issuances are supported by a credit facility provided by one bank in an amount not to exceed $125 million (Canadian). This line is subject to a minimum net worth covenant. The Canadian CLOC is subject to annual renewal in December 2003. The CLOC was undrawn at July 31, 2003.
Management believes the commercial paper market is stable. Risks to the stability of the Company’s commercial paper market participation would be a short-term rating downgrade, adverse changes in the Company’s financial performance, non-renewal or termination of the CLOCs, adverse publicity and operational risk within the commercial paper market. Management believes if any of these events were to occur, the CLOCs, to the extent available, could be used for an orderly exit from the commercial paper market, though at a higher cost to the Company. Additionally, the Company could turn to other sources of liquidity, including cash, debt issuance under the existing shelf registration and asset sales or securitizations.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
In fiscal year 2000, HRB Royalty, Inc. (HRB Royalty), a wholly owned subsidiary of the Company, placed most of its major franchises on notice that it would not be renewing their respective franchise agreements as of the next renewal date. The agreements have expired or will expire on varying dates in fiscal years 2004 and 2005. Pursuant to the terms of the applicable franchise agreements, HRB Royalty must pay the major franchisee a “fair and equitable price” for the franchise business and such price shall not be less than eighty percent of the franchisee’s revenues for the most recent twelve months ended April 30, plus the value of equipment and supplies, and certain off-season expenses. If the Company were to acquire all of the major franchises with expiring franchise agreements, the purchase price based upon the amount specified in such agreements is estimated to be $105.0 million. The Company may acquire the franchise businesses over the next two fiscal years, however, due to continuing litigation and possible negotiations with major franchisees, there is no certainty all of the major franchise businesses involved in the litigation will be acquired or that HRB Royalty and certain major
48
franchisees will not agree to other arrangements, some of which may not require the above payment. Additionally, the timing and cost of acquisition as to any major franchise business is not certain due partially to related litigation.
During the three months ended July 31, 2003, franchise agreements of two major franchisees expired and subsidiaries of the Company began operating these as company-owned operations in the tax preparation business. Cash payments of $5.0 million were made to former major franchisees during the quarter. In August 2003, a subsidiary of the Company entered into a transaction with one of the major franchisees whose franchise agreements expired in the first quarter, pursuant to which such subsidiary acquired the stock of the franchisee and the franchisee released the Company and its affiliates from any further liability regarding additional payments under the major franchise agreements. In addition, an agreement was reached during the first quarter of fiscal year 2004 between a Company subsidiary and one major franchise on a new franchise agreement with a limited term and a release of the Company and its affiliates from any liability in the litigation, including any liability regarding payments for the franchise business under the prior major franchise agreement. With the exception of the franchisees that have executed releases, the courts will determine if any additional payments are required for these franchise businesses. The first trial relating to one major franchisee is scheduled to take place in October 2003. The payments made in the first quarter are included in goodwill at July 31, 2003 and evaluation of other identifiable intangible assets will be made at the time the final purchase price is determined.
There have been no other material changes in the Company’s contractual obligations and commercial commitments from those reported at April 30, 2003 in the Company’s Annual Report on Form 10-K.
REGULATORY ENVIRONMENT
Certain state laws restrict or prohibit prepayment penalties on mortgage loans, and the Company has relied on the federal Alternative Mortgage Transactions Parity Act (Parity Act) and related rules issued in the past by the Office of Thrift Supervision (OTS) to preempt state limitations on prepayment penalties. The Parity Act was enacted to extend to financial institutions, other than federally chartered depository institutions, the federal preemption that federally chartered depository institutions enjoy. However, on September 25, 2002, the OTS released a new rule that will reduce the scope of the Parity Act preemption and, as a result, the Company will no longer be able to rely on the Parity Act to preempt state restrictions on prepayment penalties. The effective date of the new rule, originally January 1, 2003, was subsequently extended by the OTS until July 1, 2003 in response to concerns from interested parties about the burdens associated with compliance. The elimination of this federal preemption will require compliance with state restrictions on prepayment penalties. These restrictions prohibit the Company from charging any prepayment penalty in six states and restrict the amount or duration of prepayment penalties that the Company may impose in an additional eleven states. This may place the Company at a competitive disadvantage relative to financial institutions that will continue to enjoy federal preemption of such state restrictions. Such institutions will be able to charge prepayment penalties without regard to state restrictions and, as a result, may be able to offer loans with interest rate and loan fee structures that are more attractive than the interest rate and loan fee
49
structures that the Company is able to offer. It is estimated that the net impact to Mortgage Operations will be a reduction in revenues of approximately $35.0 million in fiscal year 2004 as a result of the elimination of prepayment penalties.
The United States, various state, local, provincial and foreign governments and some self-regulatory organizations have enacted statutes and ordinances, and/or adopted rules and regulations, regulating aspects of the businesses in which the Company’s subsidiaries are involved, including, but not limited to, commercial income tax return preparers, income tax courses, the electronic filing of income tax returns, the facilitation of refund anticipation loans, loan originations and assistance in loan originations, mortgage lending, privacy, consumer protection, franchising, sales methods, brokers, broker-dealers and various aspects of securities transactions, financial planners, investment advisors, accountants and the accounting practice. The Company’s subsidiaries seek to determine the applicability of such statutes, ordinances, rules and regulations (collectively, Laws) and comply with those Laws that apply to their activities. From time to time in the ordinary course of business, the Company and its subsidiaries receive inquiries from governmental and self-regulatory agencies regarding the applicability of Laws to the products and services offered by the Company’s subsidiaries. In response to past inquiries, the Company’s subsidiaries have agreed to comply with such Laws, convinced the authorities that such Laws were not applicable or that compliance already exists, and/or modified such subsidiaries’ activities in the applicable jurisdiction to avoid the application of all or certain parts of such Laws. The Company’s management believes that the past resolution of such inquiries and its ongoing compliance with Laws have not had a material adverse effect on the consolidated financial statements of the Company and its subsidiaries. The Company cannot predict what effect future Laws, changes in interpretations of existing Laws, or the results of future regulator inquiries with respect to the applicability of Laws may have on the Company’s subsidiaries, the consolidated financial statements of the Company and its subsidiaries.
FORWARD-LOOKING INFORMATION
The information contained in this Form 10-Q and the exhibits hereto may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such statements are based upon current information, expectations, estimates and projections regarding the Company, the industries and markets in which the Company operates, and management’s assumptions and beliefs relating thereto. Words such as “will,” “plan,” “expect,” “remain,” “intend,” “estimate,” “approximate,” and variations thereof and similar expressions are intended to identify such forward-looking statements. 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 that are difficult to predict. Therefore, actual outcomes and results could materially differ from what is expressed, implied or forecast in such forward-looking statements. Such differences could be caused by a number of factors including, but not limited to, the uncertainty of laws, legislation, regulations, supervision and licensing by Federal, state and local authorities and self-regulatory organizations and their impact on any lines of business in which the Company’s subsidiaries are involved; unforeseen compliance costs; the uncertainty that the Company will achieve or exceed its revenue, income and earnings per share growth goals and expectations for fiscal year 2004; the uncertainty that actual fiscal year 2004 financial results will fall within the guidance provided
50
by the Company; the uncertainty that the growth rate for mortgage originations in the Mortgage Operations segment will equal or exceed the growth rate experienced in fiscal year 2003 or the first quarter of fiscal year 2004; the uncertainty as to the effect on the consolidated financial statements of the adoption of accounting pronouncements; risks associated with sources of liquidity for each of the lines of business of the Company; changes in interest rates; changes in economic, political or regulatory environments; changes in competition and the effects of such changes; the inability to implement the Company’s strategies; changes in management and management strategies; the Company’s inability to successfully design, create, modify and operate its computer systems and networks; the uncertainty of assumptions utilized to estimate cash flows from residual interests in securitizations and mortgage servicing rights; the uncertainty of assumptions and criteria used in the testing of goodwill and long-lived assets for impairment; litigation involving the Company and its subsidiaries; the uncertainty as to the outcome of any litigation; the uncertainty as to the timing or cost of acquisition as to any franchise business; and risks described from time to time in reports and registration statements filed by the Company and its subsidiaries with the Securities and Exchange Commission. Readers should take these factors into account in evaluating any such forward-looking statements. The Company undertakes no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in market risk from those reported at April 30, 2003 in the Company’s Annual Report on Form 10-K.
CONTROLS AND PROCEDURES
Disclosure controls are procedures that are designed to ensure information is recorded, processed, summarized and reported in accordance with the rules of the Securities and Exchange Commission. Disclosure controls are also designed to ensure such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosures.
In conjunction with management, including the Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures within 90 days prior to the filing date of this quarterly report. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded these controls and procedures 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.
51
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
RAL Litigation
The Company reported in current reports on Forms 8-K, previous quarterly reports on Form 10-Q and in its annual report on Form 10-K for the year ended April 30, 2003, certain events and information relating to class action litigation and putative class action litigation involving its subsidiaries’ refund anticipation loan program (collectively, “RAL Cases”). The Company has defended numerous class action and putative class action lawsuits filed against it involving the RAL program and a variety of legal theories asserted by plaintiffs. The amounts claimed in these lawsuits have been substantial in some instances. Of the cases that are no longer pending, some were dismissed on the Company's motions for dismissal or summary judgment, some were dismissed voluntarily by the plaintiffs after a denial of class certification, and some were settled. Two RAL Cases involving statewide classes (discussed below) had preliminary or final trial court approvals of settlements during the first quarter of fiscal year 2004 and two other RAL Cases were dismissed in August 2003 in connection with one of those settlements. One new putative class action RAL Case was filed in August 2003. The Company continues to believe it has meritorious defenses to the RAL Cases and intends to defend the remaining RAL Cases vigorously. However, there can be no assurances as to the outcome of the pending RAL Cases, individually or in the aggregate, and there can be no assurances on the impact of the RAL Cases on the Company’s financial position. The following is updated information regarding the pending RAL Cases in which developments occurred during or after the three months ended July 31, 2003:
Ronnie and Nancy Haese, et al. v. H&R Block Inc., et al., Case No. CV96-4213, District Court of Kleberg County, Texas, (“Haese I”) and Ronnie and Nancy Haese, et al. v. H&R Block Inc., et al., Case No. CV-99-314-D, District Court of Kleberg County, Texas (“Haese II”), filed originally as one action on July 30, 1996. On November 19, 2002, the Company announced that a settlement had been reached pursuant to which the Company and its major franchisee will issue coupons to class members that may be redeemed over a five-consecutive-year period following final approval of the settlement and once all appeals have been exhausted. Each class member will receive a packet containing 15 coupons under the settlement. Three coupons will be redeemable each year – one for a $20 rebate off tax services at Block offices, one that may be redeemed for TaxCut® Platinum tax preparation software, and one that may be redeemed for Tax Planning Advisor, a tax planning book. The settlement also provides that defendants will be responsible for the payment of court-approved legal fees up to $49 million and expenses of class counsel up to $900,000. As a result of the settlement announcement, the Company recorded a liability and pretax expense of $41.7 million during the second quarter of fiscal year 2003, which represented, at that time, the Company’s best estimate of its share of the settlement cost for plaintiff class attorneys’ fees and expenses, tax products and associated mailing expenses. The Company recorded an additional liability and pretax expense of $3.1 million as of July 31, 2003, for a total liability and pretax charge of $46.6 million through July 31, 2003. During the fourth quarter of fiscal year 2003 and prior to the filing of the final settlement agreement with the court and any motions for preliminary approval of the settlement and legal fees and expenses of class
52
counsel, the plaintiffs filed a motion asking the Texas court to direct that $26 million of awarded class counsel fees be paid to the plaintiff class members. The final settlement agreement was filed with the District Court in March 2003 and preliminary approval of the settlement agreement was granted by the court on March 31, 2003. Notice of the settlement was sent to the class, a hearing on the final approval of the settlement agreement was held on June 24, 2003, and the judge entered a final judgment on June 24, 2003 fully and finally approving the settlement agreement, finding it fair, adequate and reasonable and that it protects the rights of the class, is in the best interests of the settlement class and meets all criteria required by Texas law. As a part of the final judgment, the court also (1) dismissed with prejudice the claims of class members who obtained RALs in Texas during the period from 1992 through 1996; (2) granted defendants’ Supplemental Motion for Summary Judgment as to class members who only obtained RALs from 1988 through 1991, and ordered that such defendants take nothing on their claims against the defendants; (3) granted defendants’ Motion to Compel Arbitration as to those members of the class who obtained a RAL for the first time from 1997 to 2002, and dismissed the claims of those class members without prejudice as to those members’ rights to pursue those claims through binding arbitration; (4) vacated its January 30, 1998 Order pertaining to arbitration clauses and contacts with the class; and (5) withdrew its rulings as to fiduciary duty, breach or the nature of the breach thereof, and for forfeiture as reflected in the Court’s November 6, 2002 letter. In a separate Order dated June 24, 2003, the Court found that the awarding of attorneys’ and expenses was appropriate and ordered that class counsel and objectors’ class counsel be awarded attorneys’ fees in the amount of $49.0 million on condition that, upon payment of the fees to class counsels’ trust account, class counsel shall pay $26.0 million of the attorneys’ fees to the class members pursuant to an approved distribution plan. The Order also provided that $100,000 from the award of attorneys’ fees be used to create a cy pres fund pursuant to an approved cy pres plan and specified the manner in which the remaining award of attorneys’ fees was to be distributed among the class counsel and objectors’ class counsel. There were no appeals of such final judgment and Order relating to attorneys’ fees and expenses. The Company paid the award of attorneys’ fees and expenses to class counsel on August 22, 2003. In addition to the liability that has already been recorded and/or paid, the Company will reduce revenues associated with tax preparation services as the coupons are redeemed each year. Distribution of the coupons will be made prior to the 2004 tax season.
Haese II arose from plaintiffs’ splitting off some claims from Haese I and, in connection with the settlement of Haese I, the case was dismissed on August 20, 2003.
Veronica I. Martinez, et al. v. H&R Block, Inc., et al., Case No. 02-3629-E in the District Court of Nueces County, Texas, was dismissed on August 20, 2003, in accordance with the settlement agreement involved in the settlement of Haese I.
Joel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., Block Financial Corporation, et al., renamed Lynne A. Carnegie, et al. v. Household International, Inc., H&R Block, Inc., et al., Case No. 98 C 2178, United States District Court for the Northern District of Illinois, Eastern Division. On April 15, 2003, the District Court judge declined to approve a $25 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
53
the settlement was fair. The judge appointed new counsel for the plaintiffs in May 2003 and named their client, Lynne Carnegie, as lead plaintiff. The new counsel for the plaintiffs filed an amended complaint and a motion for partial summary judgment during the quarter ended July 31, 2003. The defendants have filed a motion to dismiss, a brief in response to allegations in the plaintiffs’ amended complaint relating to class certification, and responses to plaintiffs’ motion for partial summary judgment. Extensive discovery is proceeding. The defendants requested the release of the escrowed settlement fund and the Company’s $12.5 million share of such fund is expected to be received during the second quarter of fiscal year 2004. In the fourth quarter of fiscal year 2003, the Company recorded a receivable in the amount of its $12.5 million share of the settlement fund and recorded a reserve of $12.5 million consistent with the existing settlement authority of the Board of Directors. The Company intends to defend the case vigorously and there are no assurances that the matter will result in a settlement or as to the amount of any settlement.
Belinda Peterson, et al. v. H&R Block Tax Services, Inc., Case No. 95CH2389, in the Circuit Court of Cook County, Illinois. A settlement was reached in April 2003 involving an estimated maximum total amount of $295,000. As a part of the settlement, class members who submit a claim will receive $25 in cash, with a guaranteed minimum total payout of $40,000 and a maximum total payout of $55,000. Class counsel will receive $220,000, the named class representative will receive $5,000, and it is expected that it will cost up to $15,000 to administer the settlement. Preliminary approval of the settlement was granted on June 12, 2003 and notices of the settlement and claim forms have been sent to the class. A final fairness hearing is scheduled for October 2003.
Levon and Geral Mitchell, et al. v. H&R Block and Ruth R. Wren, Case No. CV-95-2067, in the Circuit Court of Mobile County, Alabama. The court granted plaintiffs’ motion for class certification during the quarter ended July 31, 2003, and the defendants filed their notice of appeal regarding such certification on August 14, 2003.
Deadra 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. The defendants had removed this putative class action case to federal court, plaintiffs filed a motion to remand the case to state court, and such motion was granted in June 2003.
Abby Thomas, et al. v. Beneficial National Bank, H&R Block, Inc., et al., Case No. 2003-291 in the Circuit Court for Phillips County, Arkansas, was filed on August 12, 2003. It is a putative class action alleging fraudulent misrepresentation, fraudulent concealment, dual agency, breach of fiduciary duty, violation of Arkansas Deceptive and Unconscionable Trade Practices Law, violation of Arkansas’ Secret Payments or Allowance of Rebates and Refunds Law, unjust enrichment, breach of contract, deceit, and usury in connection with the RAL program. The complaint requests that the court certify a nationwide class of all persons who obtained a RAL from September 1987 through December 1997, who do not have an arbitration provision in their contract. It also seeks a subclass of class members who are 60 years of age or older, or who are Disabled Persons under Arkansas Statutes section 4-88-201. Plaintiffs seek an unspecified amount of damages, restitution, equitable relief, attorneys’ fees, and costs of court.
54
Shareholder Matter
Paul White, et al. v. H&R Block, et al., consolidated Case Numbers 02CV8965, 02CV9661, 02CV9682 and 02CV9830, respectively, in the United States District Court for the Southern District of New York, involves four cases in which the respective named plaintiffs seek to represent a class of shareholders who purchased the Company’s stock between November 8, 1997 and November 6, 2002, and allege that the Company and certain of its current and former officers and directors violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder by failing to disclose to shareholders various cases in which the Company had been sued regarding the RAL program, by failing to set adequate reserves for those cases, and by failing to disclose the supposed implications of those cases for the future of the RAL program. The four securities law cases were all assigned to the same judge and consolidated for pre-trial matters. A consolidated complaint was filed in March 2003 and the defendants responded by filing a motion to dismiss in April 2003. In response to defendants’ motion to dismiss, plaintiffs informed defendants that they desired further to amend their complaint. Defendants consented to the filing of an amended complaint as a pleading matter, the plaintiffs filed the amended complaint, and the defendants filed a motion to dismiss it in August 2003. The Company believes the claims in these actions are without merit and intends to defend them vigorously.
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, as 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. A hearing on the motion to certify both a nationwide plaintiff class and a nationwide defendant class was held on August 14, 2003, and, on August 27, 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
55
Peace of Mind product. The court ordered the parties to file a joint motion to approve class notice within 60 days after August 27, 2003.
There are two other putative class actions pending against the Company in Texas and Alabama that involve the Peace of Mind guarantee. The Texas case involves the same attorneys for the plaintiffs as are involved in the Marshalllitigation in Illinois and substantially similar allegations. The Alabama case involves allegations of selling insurance without of license in connection with the Peace of Mind program, the erroneous preparation of income tax returns that subjected plaintiffs to audits, failure to provide assistance in responding to auditors’ requests, failure to pay the penalties, interest, and additional taxes under Block’s standard guarantee and Peace of Mind programs, unjust enrichment, and breach of contract. No classes have been certified in either of these two cases. The Company believes the claims in these Peace of Mind actions are without merit and intends 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 the Company's financial condition.
Franchise Litigation
The Company is a named defendant in litigation entitled William R. Smith, Inc., et al. v. H&R Block, Inc., et al., Case No. 99-CV-206379, pending in the Circuit Court of Jackson County, Missouri (previously known as Armstrong Business Services, Inc., et al. v. H&R Block, Inc., et al.). The action was filed by 24 “major” franchisees against the Company and certain of its subsidiaries relating to alleged breaches of contract and other matters. The Company’s subsidiary, HRB Royalty, Inc., the franchisor under the applicable franchise agreements, filed a counterclaim and subsequently a motion for summary judgment seeking a declaration that HRB Royalty, Inc. could elect not to renew the major franchise agreements when their present five-year terms came to an end. Such motion for summary judgment was granted in March 2001 and upheld on appeal. HRB Royalty notified the plaintiff major franchisees in 2000 that it did not intend to renew their franchise agreements at the expiration of the current renewal terms and that the agreements would terminate at that time. The renewal dates vary among the franchisees. Pursuant to the franchise agreements, HRB Royalty must pay a “fair and equitable price” to the franchisee for franchisee’s franchise business, and such price must be no less than 80% of the franchisee’s revenues for the most recent 12 months ended April 30, plus the value of equipment and supplies, and certain off-season expenses. The Circuit Court ruled in May 2003 that major franchise agreements with renewal terms scheduled to expire prior to July 1, 2003, will expire on July 1, 2003, and other major franchise agreements will expire as their renewal terms expire commencing in September 2003 and ending in fiscal year 2005. The Court ordered defendants to pay for the franchise businesses as provided in the franchise agreements on the applicable dates of expiration. During the three months ended July 31, 2003, franchise agreements of two major franchisees expired and subsidiaries of the Company began operating these as company-owned operations in the tax preparation business. Cash payments of $5.0 million were made to former major franchisees during the quarter. In August 2003, a subsidiary of the Company entered into a transaction with one of the major franchisees whose franchise agreements expired in the first quarter, pursuant to which such subsidiary acquired the stock of the franchisee and the franchisee released the Company and its affiliates from any further liability regarding additional payments under the major franchise agreements. In addition, an agreement was reached during the first quarter of fiscal year 2004 between a Company subsidiary and one major franchise on a new franchise agreement with a limited term and a release of the Company and its affiliates from any liability in the litigation, including any liability regarding payments for the franchise business
56
under the prior major franchise agreement. With the exception of the franchisees that have executed releases, the court will determine if any additional payments are required for these franchise businesses. There is no certainty as to the timing and final cost of acquisition as to the franchise businesses.
In Smith, plaintiffs’ claims against the Company and its subsidiaries remain in the trial court. In their second amended petition, the plaintiffs seek in excess of $20 million in actual damages, punitive damages, unspecified statutory damages, declaratory, injunctive and other relief, including attorneys’ fees under allegations of breach of contract, breach of the covenant of good faith and fair dealing, unfair business practices, state anti-trust violations, breach of fiduciary duty, prima facie tort, violations of various state franchise statutes, fraud and misrepresentation, waiver and estoppel, ambiguity and reformation, relief with respect to a post-termination covenant not to compete in the franchise agreements, and a request for a fair and equitable payment upon nonrenewal of the franchise agreements. The major franchisees allege, among other things, that the sale of TaxCut income tax return preparation software and online tax services and the purchase of accounting firms encroached on their exclusive franchise territories. The defendants believe that the allegations against them are without merit and continue to defend the case vigorously. Management believes that amounts, if any, required to be paid by the Company and its subsidiaries in the discharge of liabilities or settlements relating to these claims of the plaintiffs in this litigation will not have a material adverse effect on the Company’s consolidated results of operations or financial position.
A trial previously scheduled for September 2003 involving two of the plaintiffs in the Smith litigation has now been rescheduled for October 2003 and such trial will now involve only one plaintiff, a former major franchisee whose franchise agreement expired on July 1, 2003. The trial will resolve the issues relating to that plaintiff’s claims against the Company and to determine if any additional payments are required to provide the former franchisee with a fair and equitable price for the franchise business.
Other Claims and Litigation
The Company and its subsidiaries have from time to time been party to claims and lawsuits not discussed herein arising out of its business operations, including additional claims and lawsuits concerning RALs and the Peace of Mind guarantee program, and claims and lawsuits concerning 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, the mortgage business, intellectual property disputes, and contract disputes. Such 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. The Company’s management considers these cases to be ordinary, routine litigation incidental to its business, believes and Company and its subsidiaries have meritorious defenses to each of them, and is defending, or intends to defend, them vigorously. While management cannot provide assurance that the Company and its subsidiaries will ultimately prevail in each instance, management believes that amounts, if any, required to be paid by the Company and its
57
subsidiaries in the discharge of liabilities or settlements in these other matters will not have a material adverse effect on the Company’s consolidated results of operations or financial position.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
The registrant filed a current report on Form 8-K dated May 12, 2003, reporting under Item 4 thereof its independent accountants, PricewaterhouseCoopers LLP, had informed management that it declined to stand for re-election as the registrant’s independent accountants.
The registrant filed a current report on Form 8-K dated June 11, 2003, reporting under Item 12 thereof its issuance of a press release announcing the results of operations for its fourth quarter and fiscal year ending April 30, 2003.
The registrant filed a current report on Form 8-K dated June 24, 2003, reporting under Item 5 thereof the final settlement and approval of the HaeseRAL class action litigation in Texas.
The registrant filed a current report on Form 8-K dated July 10, 2003, reporting under Item 4 thereof the appointment of KPMG LLP as its new independent accountants.
58
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.
59