SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
OR
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 February 28, 2005 was 165,256,051 shares.
Form 10-Q for the Period Ended January 31, 2005
Table of Contents
See Notes to Condensed Consolidated Financial Statements
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CONDENSED CONSOLIDATED INCOME STATEMENTSUnaudited, amounts in thousands, except per share amounts
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSUnaudited, amounts in thousands
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The condensed consolidated balance sheet as of January 31, 2005, the condensed consolidated income statements for the three and nine months ended January 31, 2005 and 2004, and the condensed consolidated statements of cash flows for the nine months ended January 31, 2005 and 2004 have been prepared by the Company, without audit. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows at January 31, 2005 and for all periods presented have been made.
“H&R Block,” “the Company,” “we,” “our” and “us” are used interchangeably to refer to H&R Block, Inc. or to H&R Block, Inc. and its subsidiaries, as appropriate to the context.
Certain reclassifications have been made to prior year amounts to conform to the current year presentation. Most notably, we reclassified $57.6 million and $125.9 million previously reported as interest income to gains on sales of mortgage assets for the three and nine months ended January 31, 2004, respectively. These reclassifications had no effect on our results of operations or stockholders’ equity as previously reported.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in our April 30, 2004 Annual Report to Shareholders on Form 10-K and our October 31, 2004 and July 31, 2004 Forms 10-Q.
Operating revenues of the Tax Services and Business Services segments are seasonal in nature with peak revenues occurring in the months of January through April. Therefore, results for interim periods are not indicative of results to be expected for the full year.
We file our Federal and state income tax returns on a calendar year basis. The condensed consolidated income statements reflect the effective tax rates expected to be applicable for the respective full fiscal years.
Basic earnings (loss) per share is computed using the weighted average shares outstanding during each period. The dilutive effect of potential common shares is included in diluted earnings (loss) per share except in those periods with a loss. The computations of basic and diluted earnings (loss) per share are as follows:
Diluted earnings per share excludes the impact of shares of common stock issuable upon the lapse of certain restrictions or the exercise of options to purchase 15.2 million shares of stock for the nine months ended January 31, 2005, as the effect would be antidilutive due to the net loss recorded during the period. Diluted earnings per share for the three months ended January 31, 2005 and the three and nine months ended January 31, 2004 excludes the impact of 0.3 million, 283 and 3.7 million shares, respectively, issuable upon the exercise of stock options, as the effect would be antidilutive due to the
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options’ exercise prices being greater than the average market price of the common shares during the period.
The weighted average shares outstanding for the three and nine months ended January 31, 2005 decreased to 164.5 million and 165.9 million, respectively, from 176.7 million and 178.0 million last year, respectively, primarily due to our purchases of treasury shares. The effect of these purchases was partially offset by the issuance of treasury shares related to our stock-based compensation plans.
During the nine months ended January 31, 2005 and 2004, we issued 3.3 million shares and 3.8 million shares, respectively, of common stock pursuant to the exercise of stock options, employee stock purchases and awards of restricted shares, in accordance with our stock-based compensation plans.
During the nine months ended January 31, 2005, we acquired 11.3 million shares of our common stock, of which 11.2 million shares were purchased from third parties with the remaining shares swapped or surrendered to us, at an aggregate cost of $529.9 million. During the nine months ended January 31, 2004, we acquired 7.8 million shares of our common stock from third parties at an aggregate cost of $371.2 million.
We sold $21.7 billion and $16.9 billion of mortgage loans in whole loan sales to warehouse trusts (Trusts) or other buyers during the nine months ended January 31, 2005 and 2004, respectively, with gains totaling $544.4 million and $685.5 million, respectively, recorded on these sales.
Trading residual interests valued at $115.2 million and $199.0 million were securitized in NIM transactions during the nine months ended January 31, 2005 and 2004, respectively, with net cash proceeds of $98.7 million and $197.4 million received, respectively. In the prior year, additional residual interests were sold and cash proceeds of $50.1 million were received as a result of a secured financing (on-balance sheet securitization). During the third quarter of last year, the NIM trust was terminated and the related residual interests were subsequently securitized in a NIM transaction with a qualifying
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special purpose entity (QSPE). Total net additions to residual interests from NIM transactions for the nine months ended January 31, 2005 and 2004 were $16.5 million and $1.6 million, respectively.
Cash flows of $100.3 million and $128.0 million were received from the securitization trusts for the nine months ended January 31, 2005 and 2004, respectively. Cash received on residual interests is included in investing activities in the condensed consolidated statements of cash flows.
Aggregate net unrealized gains on residual interests, which had not yet been accreted into income, totaled $160.4 million at January 31, 2005 and $112.5 million at April 30, 2004. These unrealized gains are recorded net of deferred taxes in other comprehensive income, and may be recognized in income in future periods either through accretion or upon further securitization or sale of the related residual interest.
Activity related to mortgage servicing rights (MSRs) consists of the following:
Estimated amortization of MSRs for fiscal years 2005 through 2009 is $84.6 million, $70.2 million, $35.4 million, $13.8 million and $3.6 million, respectively.
The key assumptions we used to estimate the cash flows and values of the residual interests initially recorded during the three months ended January 31, 2005 and 2004 are as follows:
The key assumptions we used to estimate the cash flows and values of the residual interests and MSRs at January 31, 2005 and April 30, 2004 are as follows:
We originate both adjustable and fixed rate mortgage loans. A key assumption used to estimate the cash flows and values of the residual interests is average annualized prepayment speeds. Prepayment speeds include voluntary prepayments, involuntary prepayments and scheduled principal payments. For adjustable rate mortgages with prepayment penalties, we use an average prepayment rate of 29% in the months prior to the rate reset date, which increases to 74% in the three months immediately following the rate reset date, then subsequently declines to 50% over the remaining life of the loans. For adjustable rate mortgages without prepayment penalties, we use an average prepayment rate of 37% in the months prior to the rate reset date, which increases to 56% in the three months immediately following the rate reset date, then subsequently declines to 46% over the remaining life of the loans.
For fixed rate mortgages with prepayment penalties, we use an average prepayment rate of 30% during the months prior to the expiration of the prepayment penalties, which increases to 44% in the three months immediately following the expiration date, and remains constant at 45% over the remaining life of the loans. For fixed rate mortgages without prepayment penalties, we use an average prepayment rate of 35% over the life of the loans. Prepayment rate is projected based on actual paydown including voluntary, involuntary and scheduled principal payments.
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Expected static pool credit losses are as follows:
Static pool credit losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets outstanding at January 31, 2005, October 31, 2004, July 31, 2004 and April 30, 2004.
At January 31, 2005, the sensitivities of the current fair value of the residual interests and MSRs to 10% and 20% adverse changes in the above key assumptions are as follows:
These sensitivities are hypothetical and should be used with caution. Changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also in this table, the effect of a variation of a particular assumption on the fair value is calculated without changing any other assumptions. It is likely that changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.
Mortgage loans that have been securitized at January 31, 2005 and April 30, 2004, past due sixty days or more and the related credit losses incurred are presented below:
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Changes in the carrying amount of goodwill for the nine months ended January 31, 2005, consist of the following:
We test goodwill for impairment annually at the beginning of our fourth quarter, or more frequently if events occur indicating it is more likely than not the fair value of a reporting unit’s net assets has been reduced below its carrying value. No such impairment or events indicating impairment were identified within any of our segments during the nine months ended January 31, 2005. Our evaluation of impairment is dependent upon various assumptions, including assumptions regarding projected operating results and cash flows of reporting units. Actual results could differ materially from our projections and those differences could alter our conclusions regarding the fair value of a reporting unit and its goodwill.
Intangible assets consist of the following:
Amortization of intangible assets for the three and nine months ended January 31, 2005 was $13.6 million and $40.4 million, respectively. Amortization of intangible assets for the three and nine months ended January 31, 2004 was $15.3 million and $39.3 million, respectively. Estimated amortization of intangible assets for fiscal years 2005 through 2009 is $54.8 million, $53.3 million, $44.2 million, $42.3 million and $40.9 million, respectively.
The goodwill and intangible assets previously included in the Corporate segment as of April 30, 2004 have been reclassified to the Tax Services segment.
A summary of our derivative instruments as of January 31, 2005 and April 30, 2004, and gains or losses incurred during the three and nine months ended January 31, 2005 and 2004 follows. We enter into derivative instruments to reduce risks relating to mortgage loans we originate and sell, and therefore all gains or losses are included in gains on sales of mortgage assets, net in the condensed consolidated income statements.
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We use interest rate swaps and forward loan sale commitments to reduce interest rate risk associated with non-prime loans. We generally enter into interest rate swap arrangements related to existing loan applications with rate-lock commitments and, beginning at the end of our second quarter, for rate-lock commitments we expect to make in the next 30 days. 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.
Forward loan sale commitments for non-prime loans are not considered derivative instruments and are therefore not recorded in our financial statements. The notional value and the contract value of the forward commitments at January 31, 2005 were $4.0 billion and $4.1 billion, respectively. Most of our forward commitments give us the option to under- or over-deliver by five to ten percent.
In the normal course of business, we enter into commitments with our customers to fund prime mortgage loans for specified periods of time at “locked-in” interest rates. These derivative instruments represent commitments (rate-lock equivalents) to fund prime loans. We adopted SEC Staff Accounting Bulletin No. 105, “Application of Accounting Principles to Loan Commitments,” as of March 31, 2004. Upon adoption, we no longer record an asset at the time we enter into the commitments to fund non-prime mortgage loans.
We sell short FNMA, FHLMC and GNMA mortgage-backed securities to reduce our risk related to our commitments to fund fixed-rate prime loans. The position on certain or all of the fixed-rate mortgage loans is closed approximately 10-15 days prior to standard Public Securities Association (PSA) settlement dates.
In August 2004 we filed an additional shelf registration statement with the SEC for up to $1.0 billion in debt securities. On October 26, 2004, we issued $400.0 million of 5.125% Senior Notes under shelf registration statements. The Senior Notes are due on October 30, 2014, and are not redeemable by the bondholders prior to maturity. The proceeds from the notes were used to repay our $250.0 million in 6 3/4% Senior Notes, which were due on November 1, 2004. The remaining proceeds were used for working capital, capital expenditures, repayment of other debt and other general corporate purposes.
The components of comprehensive income are:
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
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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:
During the nine months ended January 31, 2005, we paid $406.6 million and $53.6 million for income taxes and interest, respectively. During the nine months ended January 31, 2004, we paid $245.4 million and $57.5 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:
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. We obtained an additional $750.0 million line of credit for the period of January 26 to February 25, 2005 to back-up peak commercial paper issuance or use as an alternate source of funding for RAL participations. These lines are subject to various affirmative and negative covenants, including a minimum net worth covenant. These CLOCs were undrawn at January 31, 2005.
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 errors 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:
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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 $3.2 billion and $2.6 billion at January 31, 2005 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 $36.9 million and $25.2 million at January 31, 2005 and April 30, 2004, respectively, based on historical experience. Repurchased loans are normally sold in subsequent sale transactions.
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 January 31, 2005 and April 30, 2004 was $5.3 billion and $3.2 billion, respectively. The fair value of mortgage loans held by the Trusts as of January 31, 2005 and April 30, 2004 was $5.4 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 $5.6 million and $7.8 million as of January 31, 2005 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 cost of the acquired business, generally 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 January 31, 2005 and April 30, 2004 totaled $69.1 million and $27.0 million, respectively. We have a receivable of $52.7 million and $35.9 million, which represents the amounts drawn on the FELCs, as of January 31, 2005 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 January 31, 2005.
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We have been involved in a number of class actions and putative class action cases since 1990 regarding our RAL programs. These cases are based on a variety of legal theories and allegations. These theories and allegations include, among others, that (i) we improperly did not disclose license fees we received from RAL lending banks for RALs they make to our clients, (ii) we owe and breached a fiduciary duty to our clients, and (iii) the RAL program violates laws such as state credit service organization laws and the federal Racketeer Influenced and Corrupt Organizations (RICO) Act. Although we have successfully defended many RAL cases, we incurred a substantial pretax expense in fiscal year 2003 in connection with the settlement of one RAL case. Several of the RAL cases are still pending and the amounts claimed in some of them are very substantial. We cannot estimate the range of possible loss relating to the RAL cases in light of various legal uncertainties. However, it is reasonably possible that the ultimate cost of this litigation could be substantial. We intend to continue defending the RAL cases vigorously, although there are no assurances as to their outcome.
We are also parties to claims and lawsuits pertaining to our electronic tax return filing services and our POM guarantee program associated with income tax preparation services. 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. We intend to continue defending these cases vigorously, although there are no assurances as to their outcome.
In addition to the aforementioned types of cases, we are parties to claims and lawsuits that we consider to be ordinary, routine disputes incidental to our business (Other Claims and Lawsuits), including claims and lawsuits concerning the preparation of customers’ income tax returns, the fees charged customers for various services, investment products, 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 Lawsuits 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 pertaining to Other Claims and Lawsuits will not have a material adverse effect on our consolidated financial statements. 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 the amount of the liability can be reasonably estimated. Many of the various legal proceedings are covered in whole, or in part, by insurance. Any receivable for insurance recoveries is recorded separate from the corresponding litigation reserve, and only if recovery is determined to be probable. Receivables for insurance recoveries at January 31, 2005 were immaterial.
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Information concerning our operations by reportable operating segment is as follows:
Our international operations contributed $12.5 million and $40.6 million in revenues for the three and nine months ended January 31, 2005, respectively, and $8.3 million and $14.7 million in pretax losses, respectively. Our international operations contributed $10.8 million and $35.4 million in revenues for the three and nine months ended January 31, 2004, respectively, and $6.4 million and $12.3 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.
The pretax loss from our Corporate segment for the three and nine months ended January 31, 2005 includes a non-operating gain of $16.7 million, or $0.06 per diluted share, resulting from a legal recovery.
In December 2004, Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (SFAS 123R) was issued. SFAS 123R revises the original SFAS 123 on stock-based compensation primarily by requiring all entities to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards. Compensation expense must be recognized for the unvested portions of all awards outstanding as of the date of adoption. The provisions of this standard are effective as of the beginning of our second quarter of fiscal year 2006. We are currently evaluating what effect the adoption of SFAS 123R will have on our consolidated financial statements.
In October 2004, the American Jobs Creation Act (the Act) was signed into law. The Act introduces a one-time deduction for dividends received from the repatriation of certain foreign earnings, provided certain criteria are met. We have begun our evaluation of the effects of the Act, but do not expect to be able to complete this evaluation until additional clarifying language on key elements of the Act are issued. As of January 31, 2005, we have not provided deferred taxes on foreign earnings because we intended to indefinitely reinvest such earnings outside the United States. Whether we will ultimately take advantage of this provision depends on our review of the Act and any additional guidance provided and we are therefore currently uncertain as to the impact, if any, this matter will have on our consolidated financial statements, and are unable to estimate the amount of earnings we may repatriate.
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 third 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 QSPE.
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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 January 31, 2005, the Trusts had both assets and liabilities of $5.3 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.
15. 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 nine months ended January 31, 2004 and statement of cash flows for the nine months ended January 31, 2004 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
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 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.
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Three months ended January 31, 2005 compared to January 31, 2004 Tax Services’ revenues increased $56.6 million, or 11.9%, for the three months ended January 31, 2005 compared to the prior year.
Tax preparation and related fees increased $36.1 million, or 10.7%, for the current quarter. This increase is primarily due to an increase in the average fee per U.S. client served, coupled with an increase in U.S. clients served in offices. The average fee per client served increased 6.9% to $149.94 in the current year compared to $140.25 last year. Clients served in company-owned offices during the current tax season totaled 2.4 million, up 3.6% from the prior year. We estimate that approximately $10.8 million of the total increase is due to new offices opened during the current year.
Other service revenues increased $8.1 million primarily as a result of additional revenues associated with Refund Anticipation Checks (RACs), Express IRAs and, to a lesser extent, increased revenues from POM guarantees.
The average fee per client served at franchise offices increased by 4.1%, while clients served rose 4.0%. These increases, coupled with a slight increase in the royalty rate during the current quarter, resulted in a $6.5 million increase in royalty revenue.
Revenues earned during the current quarter in connection with RAL participations totaled $43.4 million, an increase of 16.6% over the prior year. This increase is primarily due to an increase in the dollar value of loans in which we purchased participation interests, resulting from an increase in the fee charged by the lender, an increase in our clients’ average refund size, and an increase in the maximum loan amount allowed by the lender.
Cost of services for the three months ended January 31, 2005 increased $35.2 million, or 12.0%, from the prior year. Our real estate expansion efforts have contributed to increases across all cost of services categories and resulted in a net 639 new stand-alone company-owned offices and a net 300 new company-owned shared-office locations. Compensation and benefits increased $19.2 million primarily due to an increase in the number of tax professionals and support staff needed for our new offices, the increase in revenues and higher payroll tax rates. Occupancy expenses increased $8.1 million, or 12.3%, primarily as a result of higher rent expenses, due to an 11.3% increase in company-owned offices under lease and a 2.7% increase in the average rent. Utilities related to these new offices also contributed to the increase. Other cost of service expenses increased $4.6 million primarily due to additional expenses associated with our POM program.
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Selling, general and administrative expenses increased $19.4 million over the prior year primarily due to increased spending on marketing initiatives and a $5.1 million increase in legal expenses. Legal expenses increased partially due to reserves required for RAL-related litigation.
Pretax income of $64.3 million for the three months ended January 31, 2005 represents a 4.1% increase over prior year income of $61.8 million.
Due to the seasonal nature of this segment’s business, operating results for the three months ended January 31, 2005 are not comparable to the three months ended October 31, 2004 and are not indicative of the expected results for the entire fiscal year.
Nine months ended January 31, 2005 compared to January 31, 2004
Tax Services’ revenues increased $68.9 million, or 11.7%, for the nine months ended January 31, 2005 compared to the prior year.
Tax preparation and related fees increased $44.3 million, or 11.5%, for the nine months ended January 31, 2005. This increase is primarily due to an increase in the average fee per client served, coupled with an increase in U.S. clients served in offices during the first month of the tax season. Australian tax returns prepared increased 5.2% and the average charge increased 2.8%, resulting in $3.6 million of additional revenues.
Other service revenues increased $12.3 million primarily as a result of additional revenues associated with POM guarantees and, to a lesser extent, increased revenues from RACs and Express IRAs.
The average fee per client served and clients served both increased at our franchise offices, resulting in an increase in royalty revenue of 13.9%.
Revenues earned during the current year in connection with RAL participations totaled $43.5 million, an increase of 17.0% over the prior year. This increase is primarily due to an increase in the dollar amount of loans in which we purchased participation interests, resulting from an increase in the fee charged by the lender, an increase in our clients’ average refund size and the maximum loan amount allowed by the lender. This increase was offset by the elimination of RAL waiver revenue in the prior year associated with the RAL waiver agreement.
Cost of services for the nine months ended January 31, 2005 were up $56.6 million, or 10.6%, from the prior year. Compensation and benefits increased $26.9 million primarily due to an increase in the number of tax professionals and support staff needed for our real estate expansion and increased revenues. Occupancy expenses increased $19.3 million, or 12.2%, as a result of an 11.3% increase in company-owned offices under lease. Other cost of service expenses increased $5.1 million primarily due to additional expenses associated with Express IRAs.
Selling, general and administrative expenses increased $26.3 million over the prior year due to increased spending related to additional marketing efforts, legal expenses and information technology expenses.
The pretax loss of $182.6 million for the nine months ended January 31, 2005 represents an 8.6% increase over the prior year loss of $168.1 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 October 31, 2004 Form 10-Q. Clients served across our retail network through February 15, 2005 were up 4.0% and we believe we are on track to meet our expectations for the year. However, results in interim periods may not necessarily be representative of the overall results for the 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 12 to the condensed consolidated financial statements and in Part II, Item 1, “Legal Proceedings.”
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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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Three months ended January 31, 2005 compared to January 31, 2004Mortgage Services’ revenues decreased $13.0 million, or 4.1%, for the three months ended January 31, 2005 compared to the prior year. Revenues decreased as a result of a decline in gains on sales of mortgage loans and residual interests and lower accretion income, somewhat offset by gains on derivatives and increased servicing revenue.
The following table summarizes the key drivers of gains on sales of mortgage loans:
Although we continue to grow our origination volumes, up 56.8% over the prior year, gains on sales of mortgage loans declined $45.5 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 2.20% last year to 3.64% at the end of the current quarter. However, our WAC declined to 7.30% from 7.47% in the prior year. Because our WAC was not more aligned with market rates, our gross margin declined 151 basis points, to 2.42% from 3.93% last year. To mitigate the risk of short-term changes in market interest rates, we use interest rate swaps and forward loan sale commitments. During the current
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quarter, we recorded a net $30.8 million in gains, compared to losses of $7.7 million in the prior year, related to our various derivative instruments. See note 6 to the condensed consolidated financial statements.
During the current year, 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 January 31, 2004 totaled $57.6 million. This change had no impact on our net income as previously reported.
In the prior year we recorded $17.0 million in gains on sales of previously securitized residual interests, while no similar transaction occurred in the current year.
Impairments of residual interests in securitizations of $4.8 million were recognized during the current quarter, compared with $14.9 million in the prior year.
The following table summarizes the key drivers of loan servicing revenues:
Loan servicing revenues increased $17.9 million, or 32.4%, compared to the prior year. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the three months ended January 31, 2005 increased $16.1 billion, or 39.1%, to $57.3 billion.
Accretion of residual interests of $28.8 million for the three months ended January 31, 2005 represents a decrease of $18.7 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.
During the third quarter of fiscal year 2005, our residual interests continued to perform better than expected compared to internal valuation models, primarily due to credit losses performing better than originally modeled. We recorded favorable pretax mark-to-market adjustments, which increased the fair value of our residual interests $18.8 million during the quarter. These adjustments were recorded, net of write-downs of $9.0 million and deferred taxes of $3.8 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 January 31, 2005, increased $29.8 million, or 18.3%, over the year-ago quarter. This increase is primarily due to $17.3 million in increased compensation and benefits as a result of a 33.0% increase in sales associates, coupled with related increases in payroll taxes and origination-based incentives. Other expenses increased $6.2 million for the current quarter, primarily due to a $1.5 million increase in consulting expenses, and similar increases in depreciation and travel. Costs related to servicing of mortgage loans increased $3.9 million as a result of a higher average servicing portfolio during the three months ended January 31, 2005.
Pretax income decreased $42.8 million to $111.7 million for the three months ended January 31, 2005.
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Three months ended January 31, 2005 compared to October 31, 2004Mortgage Services’ revenues increased $23.0 million, or 8.2%, for the three months ended January 31, 2005, compared to the second quarter. Revenues increased due to gains on derivatives and higher servicing revenues, partially offset by lower gains on sales of mortgage loans.
Gains on sales of mortgage loans decreased $14.8 million primarily as a result of increased price competition and poorer execution in the secondary market. Market interest rates have increased to 3.64% from 2.94% in the second quarter. However our WAC declined from 7.46% to 7.30%. Because our WAC was not more aligned with market rates, our gross margin declined 41 basis points. To mitigate the risk of short-term changes in market interest rates, we use interest rate swaps and forward loan sale commitments. During the current quarter, we recorded a net $30.8 million in gains, compared to a net loss of $2.6 million in the second quarter, related to our various derivative instruments. Loan origination volumes increased 28.9% from the second quarter primarily due to the hiring of additional sales associates.
Impairments of residual interests in securitizations of $4.8 million were recognized during the third quarter.
Loan servicing revenues increased $11.0 million, or 17.8%, compared to the second quarter. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the three months ended January 31, 2005 increased $6.0 billion, or 11.7%.
Total expenses increased $17.5 million compared to the second quarter. This increase is primarily due to $11.2 million in increased compensation and benefits as a result of a 4.6% increase in sales associates, coupled with related increases in payroll taxes and origination-based incentives. Other expenses increased $2.5 million for the current quarter, primarily due to a $5.6 million increase in marketing costs, which was partially offset by a $3.2 million decrease in consulting expenses. Costs related to servicing of mortgage loans increased $3.6 million as a result of a higher average servicing portfolio.
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Pretax income increased $5.5 million, or 5.2%, for the three months ended January 31, 2005 compared to the preceding quarter.
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Nine months ended January 31, 2005 compared to January 31, 2004Mortgage Services’ revenues decreased $96.0 million, or 10.1%, for the nine months ended January 31, 2005 compared to the prior year. Revenues decreased primarily as a result of a decline in gains on sales of mortgage loans.
Although we continue to grow our origination volumes, up 27.7% over the prior year, gains on sales of mortgage loans declined $141.1 million as a result of increased price competition and poorer execution in the secondary market. Market interest rates have increased to 3.64% from 1.88% in early April and our WAC increased from 7.06% at April 30, 2004 to 7.32% at January 31, 2005. Because our WAC was not more aligned with market rates, our gross margin declined 137 basis points from last year. To mitigate the risk of short-term changes in market interest rates, we use interest rate swaps and forward loan sale commitments. During the current year, we recorded a net $28.8 million in gains, compared to a net loss of $4.3 million in the prior year, related to our various derivative instruments.
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As discussed previously, we reclassified accretion on our beneficial interest in Trusts from interest income to gain on sale. Amounts reclassified for the nine months ended January 31, 2004 totaled $125.9 million. This change had no impact on our net income as previously reported.
Impairments of residual interests in securitizations of $8.3 million were recognized in the current period, compared to $26.0 million for the nine months ended January 31, 2004.
Loan servicing revenues increased $38.6 million, or 24.9%, compared to the prior year. The increase reflects a higher loan-servicing portfolio. The average servicing portfolio for the nine months ended January 31, 2005 increased $15.3 billion, or 41.4%.
Accretion of residual interests of $86.6 million for the nine months ended January 31, 2005 represents a decrease of $31.8 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.
During the first nine months 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 $132.3 million during the year. These adjustments were recorded, net of write-downs of $33.6 million and deferred taxes of $37.7 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests.
Total expenses for the nine months ended January 31, 2005, increased $95.0 million, or 21.2%, over the prior year. This increase is primarily due to $46.3 million in increased compensation and benefits as a result of a 33.0% increase in sales associates, reflecting the overall growth in operations. Other expenses increased $25.9 million for the current period, primarily due to an $8.9 million increase in consulting expenses, and increases in depreciation and travel expenses. Costs related to servicing of mortgage loans increased $17.8 million as a result of a higher average servicing portfolio.
Pretax income decreased $190.9 million to $311.4 million for the nine months ended January 31, 2005.
Fiscal 2005 outlookDue 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. 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. 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 total cost of origination, including the effect of potentially higher origination volumes.
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BUSINESS SERVICESThis segment offers middle-market companies accounting, tax and consulting services, wealth management, retirement resources, payroll and benefits services, corporate finance and financial process outsourcing.
Three months ended January 31, 2005 compared to January 31, 2004Business Services’ revenues for the three months ended January 31, 2005 increased $20.6 million, or 18.3%, from the prior year. This increase was primarily due to a $16.2 million increase in accounting, tax and consulting revenues resulting from a 6.3% increase in the net collected rate per hour and a 10.4% increase in chargeable hours. The increase in chargeable hours is primarily due to favorable market conditions for all of our core services and strong demand for consulting and risk management services. Other service revenues increased $3.1 million as a result of growth in our financial process outsourcing business and wealth management services. Capital markets revenues declined $1.7 million as a result of an 11.5% decrease in the number of business valuation projects. Other revenues increased $1.8 million as a result of increases in computer hardware and software sales to clients.
Total expenses increased $16.6 million, or 15.0%, for the three months ended January 31, 2005 compared to the prior year. Compensation and benefits increased $12.0 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 $3.2 million primarily due to increased personnel recruiting expenses and additional costs associated with our business development initiatives. Higher expenses are also attributable to investments we are making in early-stage businesses within this segment.
Pretax income for the three months ended January 31, 2005 was $5.9 million compared to $2.0 million in the prior year.
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Nine months ended January 31, 2005 compared to January 31, 2004Business Services’ revenues for the nine months ended January 31, 2005 increased $51.2 million, or 16.0%, from the prior year. This increase was primarily due to a $44.7 million increase in accounting, tax and consulting revenues resulting from a 5.7% increase in the net collected rate per hour and a 10.1% increase in chargeable hours. Additionally, reimbursable expenses and contractor revenues contributed $2.3 million and $3.8 million, respectively, to this increase. Other service revenues increased $6.5 million due to our wealth management services and the acquisition of our financial process outsourcing business in the second quarter of last year, coupled with baseline growth in this business. Capital markets revenues declined $5.5 million as a result of a 13.0% decrease in the number of business valuation projects. Other revenues increased $4.2 million as a result of increases in network product fees and computer hardware and software sales to clients.
Total expenses increased $52.8 million, or 16.1%, for the nine months ended January 31, 2005 compared to the prior year. Compensation and benefits increased $41.3 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 reimbursable expenses billed to clients and contractor fees. Selling, general and administrative expenses increased $2.7 million primarily due to increased personnel recruiting expenses and additional costs associated with our strategic growth initiatives. Higher expenses are also attributable to investments we are making in early-stage businesses within this segment.
The pretax loss for the nine months ended January 31, 2005 was $9.0 million compared to $7.5 million in the prior year.
Fiscal 2005 outlookOur fiscal year 2005 outlook for our Business Services segment is unchanged from the discussion in our April 30, 2004 Form 10-K and our October 31, 2004 Form 10-Q.
INVESTMENT SERVICESThis 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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Three months ended January 31, 2005 compared to January 31, 2004Investment Services’ revenues, net of interest expense, for the three months ended January 31, 2005 increased $3.5 million, or 6.1%.
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Production revenue increased $1.2 million, or 2.9%, over the prior year. Transactional revenue, which is based on individual securities transactions, decreased $1.9 million, or 7.0%, from the prior year due primarily to a 15.8% decline in transactional trading volume. This decline was partially offset by an increase in average revenue per trade. Annuitized revenue, which is based on sales of mutual funds, insurance, fee based products and unit investment trusts, increased $3.1 million, or 20.0%, due to increased sales of annuities and mutual funds. Annualized productivity averaged approximately $172,000 per advisor during the current quarter compared to $185,000 per advisor in the prior year. Declining productivity was primarily due to advisor attrition.
Margin interest revenue increased $3.6 million, or 43.2%, from the prior year, as a result of a 4.9% increase in average margin balances and higher interest rates earned.
Cost of services increased $2.3 million, or 6.0%, primarily as a result of $2.0 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 $6.7 million, or 20.9%, over the prior year primarily as the result of gains of $2.2 million on the disposition of certain assets in the prior year, an increase of $2.1 million in legal expenses and $1.8 million in additional stock-based compensation.
The pretax loss for Investment Services for the third quarter of fiscal year 2005 was $18.3 million compared to the prior year loss of $12.8 million.
Three months ended January 31, 2005 compared to October 31, 2004Investment Services’ revenues, net of interest expense, for the three months ended January 31, 2005 increased $7.8 million, or 14.6% compared to the preceding quarter.
Production revenue increased $5.8 million, or 15.7%, over the second quarter. Transactional revenue increased $4.7 million, or 23.3%, compared to the preceding quarter, primarily due to a 31.1% increase in transactional trading volume partially offset by a decline in average revenue per trade. Annuitized revenues rose $1.2 million, or 6.9%, due to increased mutual fund sales and trailer revenue. A total of 86 new advisors were recruited during the quarter. Our total advisor count increased from 982 to 1,013 during the period as a result of our recruiting efforts and declining advisor attrition.
Margin interest revenue increased $1.9 million, or 19.3%, from the preceding quarter, which is primarily a result of higher interest rates earned.
Cost of services increased $4.1 million, or 11.2%, principally due to a $1.9 million rise in compensation and benefits, primarily resulting from higher production revenues.
Selling, general and administrative expenses decreased $2.5 million, or 6.1%, primarily due to a $6.0 million write-down of a branch office facility during the second quarter, partially offset by gains on the disposition of certain assets during the second quarter and $1.5 million in additional stock-based compensation recorded in the current quarter.
The pretax loss for the Investment Services segment was $18.3 million, compared to a loss of $24.6 million in the second quarter.
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Nine months ended January 31, 2005 compared to January 31, 2004Investment Services’ revenues, net of interest expense, for the nine months ended January 31, 2005 increased $1.1 million, or 0.7%.
Production revenue increased $1.9 million, or 1.6%, over the prior year. Transactional revenue decreased $10.1 million, or 13.5%, from the prior year due primarily to a 20.0% decline in transactional
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trading volume, which was partially offset by an increase in the average revenue per trade. Annuitized revenues increased $12.0 million, or 28.4%, 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.
Other service revenue declined $6.6 million, or 25.1%, from the prior year due to fewer fixed income underwriting offerings and Express IRA revenues now being recorded in Tax Services.
Margin interest revenue increased $5.8 million, or 23.3%, from the prior year, as a result of a 12.7% increase in average margin balances and higher interest rates earned. Margin balances have increased from an average of $528 million for the nine months ended January 31, 2004 to $595 million in the current period.
Cost of services increased $8.8 million, or 8.2%, primarily due to $11.0 million of additional compensation and benefits. This increase is 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 building sales and asset roll offs related to the move from owned office facilities to leased facilities.
Selling, general and administrative expenses increased $11.6 million, or 11.4%, over the prior year primarily as the result of the $6.0 million write-down of a branch office facility and an increase of $5.0 million in legal expenses.
The pretax loss for Investment Services was $61.1 million compared to the prior year loss of $41.9 million.
Fiscal 2005 outlookIn our April 30, 2004 Form 10-K we indicated we believed a key to this segment's profitability was the recruitment and retention of experienced financial advisors. Our recruiting efforts during the year have improved. However, advisor attrition remains consistent with industry levels and, as a result, recruitment efforts have been fully offset by attrition rates that were higher than planned. We have expanded our partner programs with Tax Services, and have both licensed and unlicensed tax professionals teamed with financial advisors. We are planning for improvements in this business as we better align this segment’s cost structure with its revenue stream. Given our performance to date and revised internal forecasts, we expect our fiscal year 2005 pretax loss to be approximately 25% larger than the prior year.
CORPORATEThis 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 and franchise financing subsidiaries are also included within this segment.
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Three months ended January 31, 2005 compared to January 31, 2004Corporate expenses increased $1.9 million primarily due to higher interest expense, resulting from higher interest rates and higher average debt balances.
Other support department expenses increased $8.7 million, primarily due to $5.7 million of additional stock-based compensation expenses and increases in the cost of employee insurance and supply sales to franchises.
Other income increased $17.2 million primarily as a result of a $16.7 million legal recovery we received during the current quarter.
The pretax loss was $12.0 million, compared with last year’s third quarter loss of $29.3 million.
Due to the nature of this segment, the three months ended January 31, 2005 are not comparable to the three months ended October 31, 2004 and are not indicative of the expected results for the entire fiscal year.
Nine months ended January 31, 2005 compared to January 31, 2004Corporate expenses increased $12.0 million primarily due to increases in consulting and insurance costs, as well as increased allocations from the information technology, legal and human resource departments.
Marketing department expenses increased $4.7 million, or 8.9%, primarily due to additional marketing efforts in the current year. Other support department expenses increased $27.3 million, primarily due to $14.1 million of additional stock-based compensation expenses, increases in the cost of employee insurance and additional supply sales to the operating segments.
Other income increased $17.1 million primarily as a result of the $16.7 million legal recovery we received during the current year.
The pretax loss was $65.4 million, compared with last year’s loss of $72.8 million.
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 SEGMENTOur 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.
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Cash From Operations. Cash used in operations totaled $1.6 billion and $1.0 billion for the nine months ended January 31, 2005 and 2004, respectively. The increase in cash used in operating activities is primarily due to increases in receivables, principally participations in RALs, and income tax payments. RAL participation receivables increased over the prior year due to a higher dollar amount of loans in which we purchased participation interests, resulting from increases in the fee charged by the lender, our clients’ average refund size and the maximum loan amount allowed by the lender. Income tax payments totaled $406.6 million during the current year, an increase of $161.2 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 $119.9 million and $111.2 million for the nine months ended January 31, 2005 and 2004, respectively.
Debt. In August 2004 we filed an additional shelf registration statement with the SEC for up to $1.0 billion in debt securities. On October 26, 2004, we issued $400.0 million of 5.125% Senior Notes under our shelf registration statements. The Senior Notes are due on October 30, 2014, and are not redeemable by the bondholders prior to maturity. The proceeds from the notes were used to repay our $250.0 million in 6-3/4% Senior Notes, which were due on November 1, 2004. The remaining proceeds were used for working capital, capital expenditures, repayment of other debt and other general corporate purposes.
As of January 31, 2005, we had commercial paper borrowings of $1.5 billion outstanding. Commercial paper issuance supports RAL participations and various other cash requirements.
Dividends. Dividends paid totaled $106.4 million and $103.5 million for the nine months ended January 31, 2005 and 2004, 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 nine months ended January 31, 2005, 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 January 31, 2005. 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 $535.3 million at January 31, 2005. Investment Services held $520.0 million of this total segregated in a special reserve account for the exclusive benefit of customers. Restricted cash of $15.3 million at January 31, 2005 held by Business Services is related to funds held to pay payroll taxes on behalf of its customers.
Segment Cash Flows. A condensed consolidating statement of cash flows by segment for the nine months ended January 31, 2005 follows. Generally, interest is not charged on intercompany activities between segments.
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.
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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 $1.1 billion in its current nine-month operations to cover off-season costs and working capital requirements. This segment also used $77.8 million in investing activities, primarily related to capital expenditures in connection with our real estate expansion initiative.
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 $43.0 million in cash from operating activities and $62.5 million in cash from investing activities. Cash flows from investing activities consist of $100.3 million in cash receipts on residual interests, partially offset by $37.7 million in capital expenditures.
Gains on sales. Gains on sales of mortgage assets totaled $565.0 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.
(1) Includes residual interests and interest rate caps.(2) Cash proceeds divided by portion of gain on sale related to capital market transactions.
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 January 31, 2005 and April 30, 2004 the balance outstanding under this facility was $4.4 million and $4.0 million, respectively.
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 $9.0 billion as of January 31, 2005. The Mortgage Services segment is planning to implement a $3.0 billion on-balance sheet commercial paper conduit program during fiscal year 2006. At that time, we plan to 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 $0.9 million in operating cash flows during the first nine months of the year. Business Services also used $23.9 million and $19.5 million in investing and financing activities,
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respectively. Investing activities included acquisitions and capital expenditures, while financing activities consist of payments on acquisition debt.
Investment Services. Investment Services, through HRBFA, is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers.
At January 31, 2005, HRBFA’s net capital of $118.8 million, which was 18.0% of aggregate debit items, exceeded its minimum required net capital of $13.2 million by $105.6 million. During the current year, we contributed additional capital of $17.0 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 nine months of fiscal year 2005, Investment Services used $52.5 million in its operating activities primarily due to operating losses and the timing of cash deposits that are restricted for the benefit of customers. Cash provided by investing activities consists primarily of proceeds from the sale of branch offices.
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 January 31, 2005 totaled $53.5 million, an excess of $13.2 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 ARRANGEMENTSSubstantially all non-prime mortgage loans we originate are sold daily to the Trusts. The Trusts purchase the loans from us utilizing five warehouse facilities that were arranged by us, bear interest at one-month LIBOR plus 50 to 200 basis points and expire on various dates during the year. In December 2004, the warehouse facilities were increased from $8.0 billion to $9.0 billion through February 15, 2005. This increase was pursuant to an amendment to the warehouse facility with Bank of America, N.A. (the BOA Facility) as reported on our current report on Form 8-K dated December 17, 2004, which is incorporated herein by reference.
On February 15, 2005, the BOA Facility was amended further to extend the term through May 15, 2005 of the $1.0 billion in warehouse capacity added in December 2004. The additional $1.0 billion increases our maximum guarantee, which is equal to approximately 10% of the aggregate principal balance of mortgage loans held by the Trusts.
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 ISSUANCEWe 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. We obtained an additional $750.0 million line of credit for the period of January 26 to February 25, 2005 to back-up peak commercial paper issuance or use as an alternate source of funding for RAL participations. This line is subject to various covenants, substantially similar to the primary CLOCs. These CLOCs were undrawn at January 31, 2005.
At January 31, 2005, there was $25.0 million (Canadian) of commercial paper outstanding under the H&R Block Canada commercial paper program. The Canadian issuances are supported by a credit facility provided by one
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bank in an amount not to exceed $125.0 million (Canadian). The Canadian CLOC is subject to annual renewal in December 2005. The Canadian CLOC was undrawn at January 31, 2005.
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 COMMITMENTSThere 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.
REGULATORY ENVIRONMENTThere 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 INFORMATIONIn 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.
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.
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.
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As of January 31, 2005, 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 various 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, immediate corrective action was undertaken. Remediation that was complete or substantially complete at January 31, 2005 included the following:
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.
ITEM 1. LEGAL PROCEEDINGSThe information below should be read in conjunction with the information included in note 12 to our condensed consolidated financial statements.
RAL LitigationWe 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 federal Racketeer Influenced and Corrupt Organizations (RICO) Act; violations of the federal Fair Debt Collection Practices Act; and that 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
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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 consolidated financial statements. The following is updated information regarding the pending RAL Cases in which developments occurred during or after the three months ended January 31, 2005:
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 nationwide settlement of this matter, under which we and the lending bank would have each paid $12.5 million. The judge’s decision was based on a 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 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 October 2005. We intend to continue defending the case vigorously, but there are no assurances as to its outcome.
Deandra D. Cummins, et al. V. H&R Block, Inc., et al., Case No. 03-C-134, Circuit Court of Kanawha County, West Virginia. On December 30, 2004, the trial court certified a class consisting of all West Virginia residents who obtained RALs from January 1, 1994 to present. On February 23, 2005, the U.S. Supreme Court denied our request to review the West Virginia Supreme Court’s decision not to review the trial court’s denial of our motion to compel arbitration. The case is scheduled to go to trial in October 2005.
Sandra J. Basile, et al. v. H&R Block, Inc. et al., April Term 1992 Civil Action No. 3246, Court of Common Pleas, First Judicial district of Pennsylvania, Philadelphia County, instituted on April 23, 1993. On February 3, 2005, the Pennsylvania appellate court granted plaintiff’s motion for en banc review of the appellate court’s previous three-judge panel decision denying plaintiff’s appeal of the trial court class decertification. Re-argument is expected to occur in June 2005.
Peace of Mind LitigationLorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Civil Action 2002L000004, 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”
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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. No trial date has been set.
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 financial statements.
Other Claims and LitigationAs 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 concerned the trading activity by two former financial advisors, primarily on behalf of one of HRBFA’s institutional clients. After substantive discussions with the NASD, HRBFA agreed to a settlement of the matter, without admitting or denying any wrongdoing. We paid a fine of $500,000 and $325,000 restitution, to mutual fund customers.
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. Two private civil actions subsequently were filed against HRBFA concerning the matter raised in the NASD’s charges, one of which was subsequently dismissed without prejudice. We intend to defend the charges and the civil suit 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 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, the electronic filing of customers’ income tax returns and the Peace of Mind guarantee program. We believe we have meritorious defenses to each of these claims, and we are defending, or intend to defend, them vigorously, although there is no assurance as to their outcome.
In addition to the aforementioned types of cases, we are parties to claims and lawsuits that we consider to be ordinary, routine litigation incidental to our business, including claims and lawsuits (Other Claims) concerning investment products, the preparation of customers’ income 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
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settlements in these Other Claims will not have a material adverse effect on our consolidated financial statements.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIESA summary of our purchases of H&R Block common stock during the third quarter of fiscal year 2005 is as follows:
ITEM 6. EXHIBITS
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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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