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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
þ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended January 31, 2006
OR
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number 1-6089
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H&R Block, Inc.
(Exact name of registrant as specified in its charter)
MISSOURI (State or other jurisdiction of incorporation or organization) | 44-0607856 (I.R.S. Employer Identification No.) |
4400 Main Street
Kansas City, Missouri 64111
(Address of principal executive offices, including zip code)
Kansas City, Missouri 64111
(Address of principal executive offices, including zip code)
(816) 753-6900
(Registrant’s telephone number, including area code)
(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.
Yesþ Noo
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one)
Large accelerated filerþ Accelerated filero Non-accelerated filero
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yeso Noþ
The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on February 28, 2006 was 328,415,828 shares.
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Form 10-Q for the Period Ended January 31, 2006
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CONDENSED CONSOLIDATED BALANCE SHEETS
(amounts in 000s, except share amounts) | ||||||||
Restated | ||||||||
January 31, 2006 | April 30, 2005 | |||||||
(Unaudited) | ||||||||
ASSETS | ||||||||
Cash and cash equivalents | $ | 1,460,180 | $ | 1,100,213 | ||||
Cash and cash equivalents — restricted | 430,713 | 516,909 | ||||||
Receivables from customers, brokers, dealers and clearing organizations, net | 569,430 | 590,226 | ||||||
Receivables, less allowance for doubtful accounts of $56,985 and $38,879 | 1,810,945 | 418,788 | ||||||
Prepaid expenses and other current assets | 561,484 | 444,498 | ||||||
Total current assets | 4,832,752 | 3,070,634 | ||||||
Residual interests in securitizations — available-for-sale | 175,068 | 205,936 | ||||||
Beneficial interest in Trusts — trading | 279,714 | 215,367 | ||||||
Mortgage servicing rights | 262,369 | 166,614 | ||||||
Property and equipment, at cost less accumulated depreciation and amortization of $729,405 and $658,425 | 415,844 | 330,150 | ||||||
Intangible assets, net | 235,236 | 247,092 | ||||||
Goodwill, net | 1,104,267 | 1,015,947 | ||||||
Other assets | 367,091 | 286,316 | ||||||
Total assets | $ | 7,672,341 | $ | 5,538,056 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||
Liabilities: | ||||||||
Short-term borrowings | $ | 2,595,948 | $ | — | ||||
Current portion of long-term debt | 13,373 | 25,545 | ||||||
Accounts payable to customers, brokers and dealers | 851,827 | 950,684 | ||||||
Accounts payable, accrued expenses and other current liabilities | 782,744 | 564,749 | ||||||
Accrued salaries, wages and payroll taxes | 291,811 | 318,644 | ||||||
Accrued income taxes | 214,559 | 375,174 | ||||||
Total current liabilities | 4,750,262 | 2,234,796 | ||||||
Long-term debt | 916,926 | 923,073 | ||||||
Other noncurrent liabilites | 417,200 | 430,919 | ||||||
Total liabilities | 6,084,388 | 3,588,788 | ||||||
Stockholders’ equity: | ||||||||
Common stock, no par, stated value $.01 per share, 800,000,000 shares authorized, 435,890,796 shares issued at January 31, 2006 and April 30, 2005 | 4,359 | 4,359 | ||||||
Additional paid-in capital | 631,729 | 598,388 | ||||||
Accumulated other comprehensive income | 33,641 | 68,718 | ||||||
Retained earnings | 2,945,887 | 3,161,682 | ||||||
Less cost of 107,594,856 and 104,649,850 shares of common stock in treasury | (2,027,663 | ) | (1,883,879 | ) | ||||
Total stockholders’ equity | 1,587,953 | 1,949,268 | ||||||
Total liabilities and stockholders’ equity | $ | 7,672,341 | $ | 5,538,056 | ||||
See Notes to Condensed Consolidated Financial Statements
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CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(Unaudited, amounts in 000s, | ||||||||||||||||
except per share amounts) | ||||||||||||||||
Three months ended January 31, | Nine months ended January 31, | |||||||||||||||
Restated | Restated | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Revenues: | ||||||||||||||||
Service revenues | $ | 812,224 | $ | 657,306 | $ | 1,511,615 | $ | 1,196,126 | ||||||||
Other revenues: | ||||||||||||||||
Gains on sales of mortgage assets, net | 157,897 | 198,584 | 541,595 | 566,092 | ||||||||||||
Interest income | 51,074 | 50,545 | 155,337 | 138,817 | ||||||||||||
Product and other revenues | 135,552 | 129,801 | 168,236 | 163,705 | ||||||||||||
1,156,747 | 1,036,236 | 2,376,783 | 2,064,740 | |||||||||||||
Operating expenses: | ||||||||||||||||
Cost of services | 633,927 | 508,207 | 1,364,362 | 1,123,266 | ||||||||||||
Cost of other revenues | 144,663 | 133,343 | 402,884 | 307,987 | ||||||||||||
Selling, general and administrative | 344,246 | 248,114 | 740,047 | 593,177 | ||||||||||||
1,122,836 | 889,664 | 2,507,293 | 2,024,430 | |||||||||||||
Operating income (loss) | 33,911 | 146,572 | (130,510 | ) | 40,310 | |||||||||||
Interest expense | 12,211 | 13,026 | 37,031 | 48,900 | ||||||||||||
Other income, net | 3,708 | 19,732 | 13,951 | 23,250 | ||||||||||||
Income (loss) before taxes | 25,408 | 153,278 | (153,590 | ) | 14,660 | |||||||||||
Income taxes (benefit) | 13,295 | 59,542 | (56,460 | ) | 5,680 | |||||||||||
Net income (loss) | $ | 12,113 | $ | 93,736 | $ | (97,130 | ) | $ | 8,980 | |||||||
Basic earnings (loss) per share | $ | 0.04 | $ | 0.28 | $ | (0.30 | ) | $ | 0.03 | |||||||
Basic shares | 327,289 | 329,039 | 328,017 | 331,894 | ||||||||||||
Diluted earnings (loss) per share | $ | 0.04 | $ | 0.28 | $ | (0.30 | ) | $ | 0.03 | |||||||
Diluted shares | 331,935 | 334,875 | 328,017 | 337,889 | ||||||||||||
Dividends per share | $ | 0.13 | $ | 0.11 | $ | 0.36 | $ | 0.32 | ||||||||
Comprehensive income (loss): | ||||||||||||||||
Net income (loss) | $ | 12,113 | $ | 93,736 | $ | (97,130 | ) | $ | 8,980 | |||||||
Change in unrealized gain on available-for-sale securities, net | (3,002 | ) | (6,494 | ) | (32,466 | ) | 23,060 | |||||||||
Change in foreign currency translation adjustments | (7,820 | ) | 1,917 | (2,611 | ) | 9,958 | ||||||||||
Comprehensive income (loss) | $ | 1,291 | $ | 89,159 | $ | (132,207 | ) | $ | 41,998 | |||||||
See Notes to Condensed Consolidated Financial Statements
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, amounts in 000s) | ||||||||
Restated | ||||||||
Nine months ended January 31, | 2006 | 2005 | ||||||
Cash flows from operating activities: | ||||||||
Net income (loss) | $ | (97,130 | ) | $ | 8,980 | |||
Adjustments to reconcile net income (loss) to net cash used in operating activities: | ||||||||
Depreciation and amortization | 138,882 | 127,631 | ||||||
Accretion of residual interests in securitizations | (93,189 | ) | (96,242 | ) | ||||
Impairments of available-for-sale residual interests | 29,175 | 7,162 | ||||||
Additions to trading securities — residual interests in securitizations, net | (228,587 | ) | (115,213 | ) | ||||
Proceeds from net interest margin transactions, net | 195,159 | 98,743 | ||||||
Realized gain on sale of available-for-sale residual interests | (28,675 | ) | — | |||||
Additions to mortgage servicing rights | (196,245 | ) | (94,569 | ) | ||||
Amortization and impairment of mortgage servicing rights | 100,490 | 60,879 | ||||||
Net change in beneficial interest in Trusts | (64,347 | ) | (8,735 | ) | ||||
Other, net of acquisitions | (1,445,080 | ) | (1,553,069 | ) | ||||
Net cash used in operating activities | (1,689,547 | ) | (1,564,433 | ) | ||||
Cash flows from investing activities: | ||||||||
Cash received from available-for-sale residual interests | 74,931 | 100,344 | ||||||
Cash received from sale of available-for-sale residual interests | 30,497 | — | ||||||
Purchases of property and equipment, net | (167,181 | ) | (143,232 | ) | ||||
Payments made for business acquisitions, net of cash acquired | (209,816 | ) | (26,348 | ) | ||||
Other, net | 17,297 | 15,207 | ||||||
Net cash used in investing activities | (254,272 | ) | (54,029 | ) | ||||
Cash flows from financing activities: | ||||||||
Repayments of commercial paper | (2,632,444 | ) | (2,348,966 | ) | ||||
Proceeds from issuance of commercial paper | 4,678,392 | 3,877,848 | ||||||
Proceeds from other short-term borrowings | 550,000 | — | ||||||
Repayments of long-term debt | — | (250,000 | ) | |||||
Proceeds from issuance of long-term debt, net | — | 395,221 | ||||||
Dividends paid | (118,665 | ) | (106,422 | ) | ||||
Acquisition of treasury shares | (260,078 | ) | (529,852 | ) | ||||
Proceeds from issuance of common stock | 105,760 | 119,892 | ||||||
Other, net | (19,179 | ) | (35,414 | ) | ||||
Net cash provided by financing activities | 2,303,786 | 1,122,307 | ||||||
Net increase (decrease) in cash and cash equivalents | 359,967 | (496,155 | ) | |||||
Cash and cash equivalents at beginning of the period | 1,100,213 | 1,072,745 | ||||||
Cash and cash equivalents at end of the period | $ | 1,460,180 | $ | 576,590 | ||||
See Notes to Condensed Consolidated Financial Statements
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS | (Unaudited) |
1. | Basis of Presentation | |
The condensed consolidated balance sheet as of January 31, 2006, the condensed consolidated statements of income and comprehensive income for the three and nine months ended January 31, 2006 and 2005, and the condensed consolidated statements of cash flows for the nine months ended January 31, 2006 and 2005 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, 2006 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. These reclassifications had no effect on our results of operations or stockholders’ equity as previously reported. Adjustments related to the restatements of previously issued financial statements are detailed in note 2.
On June 8, 2005, our Board of Directors declared a two-for-one stock split of the Company’s Common Stock in the form of a 100% stock distribution, effective August 22, 2005, to shareholders of record as of the close of business on August 1, 2005. All share and per share amounts in this document have been adjusted to reflect the effect of the stock split.
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, 2005 Annual Report to Shareholders on Form 10-K/A.
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.
2. | Restatements of Previously Issued Financial Statements | |
(A) On February 22, 2006, management and the Audit Committee of the Board of Directors concluded to restate previously issued consolidated financial statements for the fiscal quarters ended October 31, 2005 and July 31, 2005, the fiscal years ended April 30, 2005 and 2004 and the related fiscal quarters. We arrived at this conclusion during the course of our closing process for the quarter ended January 31, 2006. This restatement pertains primarily to errors in determining the Company’s state effective income tax rate, including errors in identifying changes in state apportionment, expiring state net operating losses and related factors. These errors resulted in an understatement of income tax expense (net of federal income tax benefit) of approximately $2.0 million and $0.2 million for the three and nine months ended January 31, 2005, respectively, an overstatement of deferred income tax assets of $1.2 million as of April 30, 2005 and an understatement of accrued income taxes of approximately $25.9 million as of April 30, 2005. The effect of the above adjustments on the condensed consolidated financial statements is set forth in “2C” below. | ||
Income tax expense for the three months ended January 31, 2006 includes $3.4 million related to the correction of errors in state income taxes relating to periods prior to May 1, 2003. These errors were determined to be immaterial to both the current fiscal year and the applicable prior period results. |
(B)On June 7, 2005, management and the Audit Committee of the Board of Directors determined that restatement of our previously issued consolidated financial statements, including financial statements for the three and nine months ended January 31, 2005, was appropriate as a result of the errors noted below. All amounts listed are pretax, unless otherwise noted.
• | An error in calculating the gain on sale of residual interests in fiscal year 2003. This error was corrected by deferring a portion of the gain on sale of residual interests as of the transaction date in fiscal year 2003 and recognizing revenue from the sale as interest income from accretion of residual interests in subsequent periods. Interest income from accretion increased $3.9 million |
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and $9.6 million for the three and nine months ended January 31, 2005, respectively. This correction also decreased impairments of residual interests $0.3 million and $1.1 million for the three and nine months ended January 31, 2005, respectively, and decreased comprehensive income $2.6 million and $6.7 million for the three and nine months ended January 31, 2005, respectively. |
• | An error in the calculation of an incentive compensation accrual at our Mortgage Services segment as of April 30, 2004. This error resulted in an overstatement of compensation expense for the nine months ended January 31, 2005 of $12.1 million. | ||
• | An error in accounting for leased properties related to rent holidays and mandatory rent escalation in our Tax Services, Mortgage Services and Investment Services segments. Rent expense was understated for the three and nine months ended January 31, 2005 by $1.2 million and $1.8 million, respectively. | ||
• | An error from the capitalization of certain branch office costs at our Investment Services segment, which should have been expensed as incurred. This error resulted in an understatement of occupancy expenses and an overstatement of depreciation expense and capital expenditures, resulting in a net overstatement of operating expenses of $0.4 million and $5.9 million for the three and nine months ended January 31, 2005, respectively. | ||
• | Errors related to accounting for acquisitions at our Business Services and Investment Services segments, the largest of which was the acquisition of OLDE in fiscal year 2000. Amortization of customer relationships was understated by $1.8 million and $5.5 million for the three and nine months ended January 31, 2005, respectively, and the provision for income taxes was overstated by approximately $3.7 million and $11.2 million, respectively, related to this error. | ||
The effect of the above adjustments on the condensed consolidated financial statements is set forth in “2C” below. |
(C)Notes 4, 5, 6, 7, 9, 13 and 15 have been restated to reflect the above described adjustments. The following is a summary of the impact of the restatements on our condensed consolidated statement of income and comprehensive income for the three and nine months ended January 31, 2005:
(in 000s, except per share amounts) | ||||||||||||||||||||
Three months ended January 31, 2005 | ||||||||||||||||||||
As Previously | ||||||||||||||||||||
Reported(1) | Adjustments(2) | Subtotal | Adjustments(3) | Restated | ||||||||||||||||
Gain on sale of mortgage assets, net | $ | 198,301 | $ | 283 | $ | 198,584 | $ | — | $ | 198,584 | ||||||||||
Interest income | 46,599 | 3,946 | 50,545 | — | 50,545 | |||||||||||||||
Total revenues | 1,032,007 | 4,229 | 1,036,236 | — | 1,036,236 | |||||||||||||||
Total operating expenses | 887,030 | 2,634 | 889,664 | — | 889,664 | |||||||||||||||
Operating income | 144,977 | 1,595 | 146,572 | — | 146,572 | |||||||||||||||
Income before taxes | 151,683 | 1,595 | 153,278 | — | 153,278 | |||||||||||||||
Income taxes | 59,991 | (2,478 | ) | 57,513 | 2,029 | 59,542 | ||||||||||||||
Net income | 91,692 | 4,073 | 95,765 | (2,029 | ) | 93,736 | ||||||||||||||
Basic earnings per share | $ | 0.28 | $ | 0.01 | $ | 0.29 | $ | (0.01 | ) | $ | 0.28 | |||||||||
Diluted earnings per share | $ | 0.27 | $ | 0.02 | $ | 0.29 | $ | (0.01 | ) | $ | 0.28 | |||||||||
Change in unrealized gain on available-for-sale securities, net | $ | (3,881 | ) | $ | (2,613 | ) | $ | (6,494 | ) | $ | — | $ | (6,494 | ) | ||||||
Comprehensive income | 89,728 | 1,460 | 91,188 | (2,029 | ) | 89,159 |
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Nine months ended January 31, 2005 | ||||||||||||||||||||
As Previously | ||||||||||||||||||||
Reported(1) | Adjustments(2) | Subtotal | Adjustments(3) | Restated | ||||||||||||||||
Gain on sale of mortgage assets, net | $ | 564,949 | $ | 1,143 | $ | 566,092 | $ | — | $ | 566,092 | ||||||||||
Interest income | 129,193 | 9,624 | 138,817 | — | 138,817 | |||||||||||||||
Total revenues | 2,053,973 | 10,767 | 2,064,740 | — | 2,064,740 | |||||||||||||||
Total operating expenses | 2,035,128 | (10,698 | ) | 2,024,430 | — | 2,024,430 | ||||||||||||||
Operating income | 18,845 | 21,465 | 40,310 | — | 40,310 | |||||||||||||||
Income (loss) before taxes | (6,805 | ) | 21,465 | 14,660 | — | 14,660 | ||||||||||||||
Income taxes (benefit) | (2,215 | ) | 7,724 | 5,509 | 171 | 5,680 | ||||||||||||||
Net income (loss) | (4,590 | ) | 13,741 | 9,151 | (171 | ) | 8,980 | |||||||||||||
Basic earnings (loss) per share | $ | (0.01 | ) | $ | .04 | $ | 0.03 | $ | — | $ | 0.03 | |||||||||
Diluted earnings (loss) per share | $ | (0.01 | ) | $ | .04 | $ | 0.03 | $ | — | $ | 0.03 | |||||||||
Change in unrealized gain on available-for-sale securities, net | $ | 29,714 | $ | (6,654 | ) | $ | 23,060 | $ | — | $ | 23,060 | |||||||||
Comprehensive income | 35,082 | 7,087 | 42,169 | (171 | ) | 41,998 |
(1) | As reported in our Form 10-Q filed on March 9, 2005 for the nine months ended January 31, 2005. Amounts have been reclassified to conform to current year presentation. See discussion of reclassifications in note 1. | |
(2) | Adjusted to reflect the restatement described in “2B” above, as derived from the Company’s Form 10-K/A filed on August 5, 2005 for the fiscal year ended April 30, 2005. | |
(3) | Adjusted to reflect the restatement described in “2A” above. |
The following is a summary of the impact of the restatements on our condensed consolidated statement of cash flows for the nine months ended January 31, 2005:
(in 000s) | ||||||||||||||||||||
As Previously | ||||||||||||||||||||
Reported(1) | Adjustments(2) | Subtotal | Adjustments(3) | Restated | ||||||||||||||||
Net income (loss) | $ | (4,590 | ) | $ | 13,741 | $ | 9,151 | $ | (171 | ) | $ | 8,980 | ||||||||
Depreciation and amortization | 122,305 | 5,326 | 127,631 | — | 127,631 | |||||||||||||||
Accretion of residual interests in securitizations | (86,618 | ) | (9,624 | ) | (96,242 | ) | — | (96,242 | ) | |||||||||||
Impairment of available-for-sale residual interests | 8,304 | (1,142 | ) | 7,162 | — | 7,162 | ||||||||||||||
Other, net of acquisitions | (1,550,688 | ) | (2,552 | ) | (1,553,240 | ) | 171 | (1,553,069 | ) | |||||||||||
Net cash used in operating activities | (1,570,182 | ) | 5,749 | (1,564,433 | ) | — | (1,564,433 | ) | ||||||||||||
Purchases of property and equipment, net | (137,483 | ) | (5,749 | ) | (143,232 | ) | — | (143,232 | ) | |||||||||||
Net cash used in investing activities | (48,280 | ) | (5,749 | ) | (54,029 | ) | — | (54,029 | ) |
(1) | As reported in our Form 10-Q filed on March 9, 2005 for the nine months ended January 31, 2005. Amounts have been reclassified to conform to current year presentation. See discussion of reclassifications in note 1. | |
(2) | Adjusted to reflect the restatement described in “2B” above, as derived from the Company’s Form 10-K/A filed on August 5, 2005 for the fiscal year ended April 30, 2005. | |
(3) | Adjusted to reflect the restatement described in “2A” above. |
The restatements had no impact on our cash flows from financing activities as previously reported.
3. | Business Combinations | |
Effective October 1, 2005, we acquired all outstanding common stock of American Express Tax and Business Services, Inc. for an aggregate purchase price of $191.7 million, subject to a post-closing adjustment based upon determination of the final September 30, 2005 net asset value. During the three months ended January 31, 2006, we completed the final valuation of intangible assets. Results related to American Express Tax and Business Services, Inc. have been included in our condensed consolidated financial statements since October 1, 2005. Pro forma results of operations have not been presented because the effects of this acquisition were not material to our results. The accompanying balance sheet reflects a preliminary allocation of the purchase price to assets acquired and liabilities assumed as follows: |
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(in 000s) | ||||
Property and equipment | $ | 17,664 | ||
Other assets | 121,228 | |||
Liabilities | (51,701 | ) | ||
Amortizing intangible assets | 28,100 | |||
Goodwill | 76,383 | |||
$ | 191,674 | |||
Goodwill recognized in these transactions is included in the Business Services segment and is not deductible for tax purposes. The preliminary purchase price allocations are subject to change and will be adjusted based upon resolution of several matters including, but not limited to, the following:
• | Determination of the post-closing adjustment and final purchase price; | ||
• | Determination of final liabilities relating to planned exit activities; and | ||
• | Determination of the tax basis of acquired assets and liabilities, and deferred tax balances of the acquired business. |
4. | Earnings (Loss) Per Share | |
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: |
(in 000s, except per share amounts) | ||||||||||||||||
Three months ended January 31, | Nine months ended January 31, | |||||||||||||||
Restated | Restated | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Net income (loss) | $ | 12,113 | $ | 93,736 | $ | (97,130 | ) | $ | 8,980 | |||||||
Basic weighted average common shares | 327,289 | 329,039 | 328,017 | 331,894 | ||||||||||||
Potential dilutive shares from stock options and restricted stock | 4,644 | 5,834 | — | 5,993 | ||||||||||||
Convertible preferred stock | 2 | 2 | — | 2 | ||||||||||||
Dilutive weighted average common shares | 331,935 | 334,875 | 328,017 | 337,889 | ||||||||||||
Earnings (loss) per share: | ||||||||||||||||
Basic | $ | 0.04 | $ | 0.28 | $ | (0.30 | ) | $ | 0.03 | |||||||
Diluted | 0.04 | 0.28 | (0.30 | ) | 0.03 |
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 29.3 million shares of stock for the nine months ended January 31, 2006 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, 2006 and the three and nine months ended January 31, 2005 excludes the impact of 7.1 million, 0.7 million and 1.4 million shares, respectively, issuable upon the exercise of stock options, as the effect would be antidilutive due to the 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, 2006 decreased to 327.3 million and 328.0 million, respectively, from 329.0 million and 331.9 million last year, 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 each of the nine month periods ended January 31, 2006 and 2005, we issued 6.3 million and 6.5 million shares of common stock, respectively, 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, 2006, we acquired 9.2 million shares of our common stock, of which 9.0 million shares were purchased from third parties with the remaining shares swapped or surrendered to us, at an aggregate cost of $260.1 million. During the nine months ended
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January 31, 2005, we acquired 22.6 million shares of our common stock, of which 22.5 million were purchased from third parties, at an aggregate cost of $529.9 million.
5. | Receivables | |
Receivables consist of the following: |
(in 000s) | ||||||||||||
January 31, 2006 | January 31, 2005 | April 30, 2005 | ||||||||||
Participation in refund anticipation loans (RALs) | $ | 900,230 | $ | 829,325 | $ | 57,084 | ||||||
Mortgage loans held for sale | 336,213 | 128,607 | 79,458 | |||||||||
Business Services accounts receivable | 312,087 | 175,140 | 178,338 | |||||||||
Receivables for tax-related fees | 115,906 | 108,331 | 5,760 | |||||||||
Loans to franchisees | 60,185 | 52,712 | 39,022 | |||||||||
Royalties from franchisees | 50,575 | 46,900 | 668 | |||||||||
Software receivables | 18,938 | 26,420 | 22,578 | |||||||||
Other | 73,796 | 87,539 | 74,759 | |||||||||
1,867,930 | 1,454,974 | 457,667 | ||||||||||
Allowance for doubtful accounts | (34,144 | ) | (21,336 | ) | (34,201 | ) | ||||||
Lower of cost or market adjustment — mortgage loans | (22,841 | ) | (11,645 | ) | (4,678 | ) | ||||||
$ | 1,810,945 | $ | 1,421,993 | $ | 418,788 | |||||||
6. | Mortgage Banking Activities | |
Activity related to available-for-sale residual interests in securitizations consists of the following: |
(in 000s) | ||||||||
Restated | ||||||||
Nine months ended January 31, | 2006 | 2005 | ||||||
Balance, beginning of period | $ | 205,936 | $ | 210,973 | ||||
Additions from net interest margin (NIM) transactions | 39,378 | 16,470 | ||||||
Cash received | (74,931 | ) | (100,344 | ) | ||||
Cash received on sale of residual interests | (30,497 | ) | — | |||||
Accretion | 87,240 | 96,242 | ||||||
Impairments of fair value | (29,175 | ) | (7,162 | ) | ||||
Other | 366 | (4 | ) | |||||
Changes in unrealized holding gains, net | (23,249 | ) | 37,356 | |||||
Balance, end of period | $ | 175,068 | $ | 253,531 | ||||
We sold $32.3 billion and $21.7 billion of mortgage loans in loan sales to warehouse trusts (Trusts) or other buyers during the nine months ended January 31, 2006 and 2005, respectively, with gains totaling $450.2 million and $544.4 million, respectively, recorded on these sales.
Net additions to trading residual interests recorded in connection with the securitization of mortgage loans totaled $228.6 million and $115.2 million during the nine months ended January 31, 2006 and 2005, respectively. Trading residuals valued at $234.5 million were securitized in net interest margin (NIM) transactions during the current year, with net cash proceeds of $195.2 million received in connection with NIM transactions. In the prior year, trading residuals valued at $115.2 million were securitized with net cash proceeds of $98.7 million received on the transactions. Total net additions to residual interests from NIM transactions for the nine months ended January 31, 2006 and 2005 were $39.4 million and $16.5 million, respectively.
During the nine months ended January 31, 2006, we completed the sale of $40.5 million of previously securitized residual interests and recorded a gain of $28.7 million. We received cash proceeds of $30.5 million and retained a $10.0 million residual interest in the sale. This sale accelerates cash flows from the residual interests and recognition of unrealized gains included in other comprehensive income.
Although we recorded residual interests classified as trading securities during the nine months ended January 31, 2006 and 2005, at the end of each quarter we had no trading residual interests outstanding. Trading residual interests are the result of the initial securitization of mortgage loans
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and are subsequently securitized in a NIM transaction. Mark-to-market adjustments on trading residuals are included in gains on sales of mortgage assets on the condensed consolidated income statement. Such adjustments resulted in a net loss of $1.4 million and a net gain of $0.6 million for the three and nine months ended January 31, 2006, respectively. Similar adjustments resulted in a net gain of $0.4 million and $5.4 million for the three and nine months ended January 31, 2005, respectively. Cash flows from trading residuals of $12.9 million were received for the nine months ended January 31, 2006 and are included in operating activities in the accompanying condensed consolidated statement of cash flows. Accretion of trading residuals totaled $3.5 million and $5.9 million for the three and nine months ended January 31, 2006, respectively, and zero in the prior year periods. There were no trading residuals recorded as of April 30, 2005.
Cash flows from available-for-sale residual interests of $74.9 million and $100.3 million were received from the securitization trusts for the nine months ended January 31, 2006 and 2005, respectively. Cash received on available-for-sale residual interests is included in investing activities in the condensed consolidated statements of cash flows.
Aggregate net unrealized gains on residual interests not yet accreted into income totaled $63.0 million at January 31, 2006 and $115.4 million at April 30, 2005. 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:
(in 000s) | ||||||||
Nine months ended January 31, | 2006 | 2005 | ||||||
Balance, beginning of period | $ | 166,614 | $ | 113,821 | ||||
Additions | 196,245 | 94,569 | ||||||
Amortization | (100,170 | ) | (60,616 | ) | ||||
Impairment | (320 | ) | (263 | ) | ||||
Balance, end of period | $ | 262,369 | $ | 147,511 | ||||
Additions to MSRs during fiscal year 2006 have increased primarily as a result of higher origination volumes, higher average loan balances and higher interest rates. In addition, during fiscal year 2006 we updated our assumptions used to value MSRs. The assumptions were updated primarily to reflect lower servicing costs, in particular interest paid to bondholders on monthly loan prepayments, and higher discount rates. These changes in assumptions increased the weighted average value of MSRs recorded during the second and third quarters by approximately $17.0 million (0.14% of loans originated) and $10.0 million (0.11% of loans originated), respectively, over the prior year. Estimated amortization of MSRs for fiscal years 2006 through 2010 is $140.5 million, $123.9 million, $61.0 million, $25.3 million and $11.8 million, respectively.
The key weighted average assumptions we used to estimate the cash flows and values of the residual interests initially recorded during the nine months ended January 31, 2006 and 2005 are as follows:
Nine months ended January 31, | 2006 | 2005 | ||||||
Estimated credit losses | 2.85 | % | 2.72 | % | ||||
Discount rate | 20.34 | % | 25.00 | % | ||||
Variable returns to third-party beneficial interest holders | LIBOR forward curve at closing |
The key weighted average assumptions we used to estimate the cash flows and values of the residual interests and MSRs at January 31, 2006 and April 30, 2005 are as follows:
January 31, 2006 | April 30, 2005 | |||||||
Estimated credit losses | 2.97 | % | 3.03 | % | ||||
Discount rate — residual interests | 21.60 | % | 21.01 | % | ||||
Discount rate — MSRs | 18.00 | % | 12.80 | % | ||||
Variable returns to third-party beneficial interest holders | LIBOR forward curve at valuation date |
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We originate both adjustable and fixed rate mortgage loans. A key assumption used to estimate the cash flows and values of the residual interests and MSRs is average annualized prepayment speeds. Prepayment speeds include voluntary prepayments, involuntary prepayments and scheduled principal payments. Prepayment rate assumptions are as follows:
Prior to | Months Outstanding After | |||||||||||
Initial Rate | Initial Rate Reset Date | |||||||||||
Reset Date | Zero - 3 | Remaining Life | ||||||||||
Adjustable rate mortgage loans: | ||||||||||||
With prepayment penalties | 31 | % | 72 | % | 41 | % | ||||||
Without prepayment penalties | 35 | % | 52 | % | 35 | % | ||||||
Fixed rate mortgage loans: | ||||||||||||
With prepayment penalties | 30 | % | 48 | % | 38 | % |
For fixed rate mortgages without prepayment penalties, we use an average prepayment rate of 32% over the life of the loans. Prepayment rate is projected based on actual paydown including voluntary, involuntary and scheduled principal payments.
Expected static pool credit losses are as follows:
Mortgage Loans Securitized in Fiscal Year | ||||||||||||||||||||||||
Prior to 2002 | 2002 | 2003 | 2004 | 2005 | 2006 | |||||||||||||||||||
As of: | ||||||||||||||||||||||||
January 31, 2006 | 4.58 | % | 2.54 | % | 2.08 | % | 2.14 | % | 2.59 | % | 2.91 | % | ||||||||||||
October 31, 2005 | 4.52 | % | 2.49 | % | 2.05 | % | 2.16 | % | 2.93 | % | 2.84 | % | ||||||||||||
July 31, 2005 | 4.53 | % | 2.53 | % | 2.03 | % | 2.20 | % | 2.86 | % | 2.70 | % | ||||||||||||
April 30, 2005 | 4.52 | % | 2.53 | % | 2.08 | % | 2.30 | % | 2.83 | % | — | |||||||||||||
April 30, 2004 | 4.46 | % | 3.58 | % | 4.35 | % | 3.92 | % | — | — |
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.
At January 31, 2006, 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:
(dollars in 000s) | ||||||||||||
Residential Mortgage Loans | ||||||||||||
NIM | Beneficial Interest | Servicing | ||||||||||
Residuals | in Trusts | Assets | ||||||||||
Carrying amount/fair value | $ | 175,068 | $ | 279,714 | $ | 262,369 | ||||||
Weighted average remaining life (in years) | 1.9 | 2.0 | 1.3 | |||||||||
Prepayments (including defaults): | ||||||||||||
Adverse 10% — $impact on fair value | $ | 3,981 | $ | (12,497 | ) | $ | (35,910 | ) | ||||
Adverse 20% — $impact on fair value | 11,679 | (17,632 | ) | (60,158 | ) | |||||||
Credit losses: | ||||||||||||
Adverse 10% — $impact on fair value | $ | (45,495 | ) | $ | (13,062 | ) | Not applicable | |||||
Adverse 20% — $impact on fair value | (77,590 | ) | (23,942 | ) | Not applicable | |||||||
Discount rate: | ||||||||||||
Adverse 10% — $impact on fair value | $ | (5,860 | ) | $ | (5,650 | ) | $ | (4,114 | ) | |||
Adverse 20% — $impact on fair value | (11,333 | ) | (11,130 | ) | (8,112 | ) | ||||||
Variable interest rates (LIBOR forward curve): | ||||||||||||
Adverse 10% — $impact on fair value | $ | (5,330 | ) | $ | (74,636 | ) | Not applicable | |||||
Adverse 20% — $impact on fair value | (9,410 | ) | (147,357 | ) | Not applicable |
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.
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Mortgage loans that have been securitized at January 31, 2006 and April 30, 2005, past due sixty days or more and the related credit losses incurred are presented below:
(in 000s) | ||||||||||||||||||||||||
Total Principal | Principal Amount of | |||||||||||||||||||||||
Amount of Loans | Loans 60 Days or | Credit Losses | ||||||||||||||||||||||
Outstanding | More Past Due | (net of recoveries) | ||||||||||||||||||||||
January 31, | April 30, | January 31, | April 30, | Three months ended | ||||||||||||||||||||
2006 | 2005 | 2006 | 2005 | January 31, 2006 | April 30, 2005 | |||||||||||||||||||
Securitized mortgage loans | $ | 11,492,170 | $ | 10,300,805 | $ | 1,017,855 | $ | 1,128,376 | $ | 27,972 | $ | 21,641 | ||||||||||||
Mortgage loans in warehouse Trusts | 11,209,456 | 6,742,387 | — | — | — | — | ||||||||||||||||||
Total loans | $ | 22,701,626 | $ | 17,043,192 | $ | 1,017,855 | $ | 1,128,376 | $ | 27,972 | $ | 21,641 | ||||||||||||
7. | Goodwill and Intangible Assets | |
Changes in the carrying amount of goodwill for the nine months ended January 31, 2006 consist of the following: |
(in 000s) | ||||||||||||||||
April 30, 2005 | Additions | Other | January 31, 2006 | |||||||||||||
Tax Services | $ | 360,781 | $ | 8,829 | $ | 192 | $ | 369,802 | ||||||||
Mortgage Services | 152,467 | — | — | 152,467 | ||||||||||||
Business Services | 328,745 | 80,929 | (1,630 | ) | 408,044 | |||||||||||
Investment Services | 173,954 | — | — | 173,954 | ||||||||||||
Total goodwill | $ | 1,015,947 | $ | 89,758 | $ | (1,438 | ) | $ | 1,104,267 | |||||||
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, 2006. 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:
(in 000s) | ||||||||||||||||||||||||
January 31, 2006 | April 30, 2005 | |||||||||||||||||||||||
Gross | Gross | |||||||||||||||||||||||
Carrying | Accumulated | Carrying | Accumulated | |||||||||||||||||||||
Amount | Amortization | Net | Amount | Amortization | Net | |||||||||||||||||||
Tax Services: | ||||||||||||||||||||||||
Customer relationships | $ | 26,962 | $ | (9,751 | ) | $ | 17,211 | $ | 23,717 | $ | (7,207 | ) | $ | 16,510 | ||||||||||
Noncompete agreements | 18,961 | (16,135 | ) | 2,826 | 17,677 | (11,608 | ) | 6,069 | ||||||||||||||||
Business Services: | ||||||||||||||||||||||||
Customer relationships | 153,227 | (77,564 | ) | 75,663 | 130,585 | (68,433 | ) | 62,152 | ||||||||||||||||
Noncompete agreements | 32,483 | (13,431 | ) | 19,052 | 27,796 | (11,274 | ) | 16,522 | ||||||||||||||||
Trade name — amortizing | 4,050 | (1,481 | ) | 2,569 | 1,450 | (995 | ) | 455 | ||||||||||||||||
Trade name — non-amortizing | 55,637 | (4,868 | ) | 50,769 | 55,637 | (4,868 | ) | 50,769 | ||||||||||||||||
Investment Services: | ||||||||||||||||||||||||
Customer relationships | 293,000 | (225,854 | ) | 67,146 | 293,000 | (198,385 | ) | 94,615 | ||||||||||||||||
Total intangible assets | $ | 584,320 | $ | (349,084 | ) | $ | 235,236 | $ | 549,862 | $ | (302,770 | ) | $ | 247,092 | ||||||||||
Amortization of intangible assets for the three and nine months ended January 31, 2006 was $16.7 million and $47.3 million, respectively. Amortization of intangible assets for the three and nine months ended January 31, 2005 was $15.5 million and $45.9 million, respectively. Estimated amortization of intangible assets for fiscal years 2006 through 2010 is $65.1 million, $56.3 million, $38.4 million, $15.0 million and $12.8 million, respectively.
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The goodwill and intangible assets added in the Business Services segment relate primarily to the acquisition of American Express Tax and Business Services, Inc., as discussed in note 3. The intangible asset valuations were completed during the quarter, however, goodwill is subject to change pending determination of the final purchase price.
8. | Derivative Instruments | |
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. A summary of our derivative instruments as of January 31, 2006 and April 30, 2005, and gains or losses incurred during the three and nine months ended January 31, 2006 and 2005 is as follows: |
(in 000s) | ||||||||||||||||||||||||
Asset (Liability) Balance at | Gain (Loss) for the Three | Gain (Loss) for the Nine | ||||||||||||||||||||||
January 31, | April 30, | Months Ended January 31, | Months Ended January 31, | |||||||||||||||||||||
2006 | 2005 | 2006 | 2005 | 2006 | 2005 | |||||||||||||||||||
Interest rate swaps | $ | 23,422 | $ | (1,325 | ) | $ | 6,292 | $ | 31,039 | $ | 91,578 | $ | 28,934 | |||||||||||
Interest rate caps | — | 12,458 | — | — | 802 | — | ||||||||||||||||||
Rate-lock equivalents | 96 | 801 | 34 | 141 | (705 | ) | 1,841 | |||||||||||||||||
Prime short sales | (333 | ) | (805 | ) | (1,266 | ) | (424 | ) | 221 | (1,949 | ) | |||||||||||||
$ | 23,185 | $ | 11,129 | $ | 5,060 | $ | 30,756 | $ | 91,896 | $ | 28,826 | |||||||||||||
We generally 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 for rate-lock commitments we expect to make in the next two to three weeks. Interest rate swaps represent an agreement to exchange interest rate payments, whereby we pay a fixed rate and receive a floating rate. As a result, these contracts increase in value as rates rise and decrease in value as rates fall. The notional amount of interest rate swaps to which we were a party at January 31, 2006 was $8.8 billion, with a weighted average duration of 1.9 years.
We generally enter into interest rate caps or swaps to mitigate interest rate risk associated with mortgage loans that will be securitized and residual interests that are classified as trading securities because they will be sold in a subsequent NIM transaction. These instruments enhance the marketability of the securitization and NIM transactions. An interest rate cap represents a right to receive cash if interest rates rise above a contractual strike rate, its value therefore increases as interest rates rise. The interest rate used in our interest rate caps is based on LIBOR.
We enter into forward loan commitments to sell our non-prime mortgage loans to manage interest rate risk. The notional value and the contract value of the forward commitments at January 31, 2006 was $5.3 billion. Most of our forward commitments give us the option to under- or over-deliver by five percent.
In the normal course of business, we enter into commitments with our customers to fund both non-prime and prime mortgage loans for specified periods of time at “locked-in” interest rates. These derivative instruments represent commitments to fund loans (“rate-lock equivalents”). The fair value of non-prime loan commitments is calculated using a binomial option model, although we do not initially record an asset for non-prime commitments to fund loans. The fair value of prime loan commitments is calculated based on the current market pricing of short sales of FNMA, FHLMC and GNMA mortgage-backed securities and the coupon rates of the eligible 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.
None of our derivative instruments qualify for hedge accounting treatment as of January 31, 2006 or April 30, 2005.
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9. | Stock-Based Compensation | |
Effective May 1, 2003, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), under the prospective transition method as described in Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” Had compensation cost for all stock-based compensation plan grants been determined in accordance with the fair value accounting method prescribed under SFAS 123, our net income (loss) and earnings (loss) per share would have been as follows: |
(in 000s, except per share amounts) | ||||||||||||||||
Three months ended January 31, | Nine months ended January 31, | |||||||||||||||
Restated | Restated | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Net income (loss) as reported | $ | 12,113 | $ | 93,736 | $ | (97,130 | ) | $ | 8,980 | |||||||
Add: Stock-based compensation expense included in reported net income (loss), net of related tax effects | 9,916 | 8,918 | 21,927 | 17,260 | ||||||||||||
Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects | (12,460 | ) | (11,599 | ) | (29,558 | ) | (25,304 | ) | ||||||||
Pro forma net income (loss) | $ | 9,569 | $ | 91,055 | $ | (104,761 | ) | $ | 936 | |||||||
Basic earnings (loss) per share: | ||||||||||||||||
As reported | $ | 0.04 | $ | 0.28 | $ | (0.30 | ) | $ | 0.03 | |||||||
Pro forma | 0.03 | 0.28 | (0.32 | ) | — | |||||||||||
Diluted earnings (loss) per share: | ||||||||||||||||
As reported | $ | 0.04 | $ | 0.28 | $ | (0.30 | ) | $ | 0.03 | |||||||
Pro forma | 0.03 | 0.27 | (0.32 | ) | — |
10. | Supplemental Cash Flow Information | |
During the nine months ended January 31, 2006, we paid $224.8 million and $63.0 million for income taxes and interest, respectively. During the nine months ended January 31, 2005, we paid $406.6 million and $53.6 million for income taxes and interest, respectively. See note 3 for discussion of cash payments made, assets acquired and liabilities assumed related to our acquisition of American Express Tax and Business Services, Inc. |
The following transactions were treated as non-cash investing activities in the condensed consolidated statement of cash flows:
(in 000s) | ||||||||
Nine months ended January 31, | 2006 | 2005 | ||||||
Residual interest mark-to-market | $ | 38,930 | $ | 98,713 | ||||
Additions to residual interests | 39,378 | 16,470 |
11. | Commitments and Contingencies | |
We maintain two unsecured committed lines of credit (CLOCs) for working capital, support of our commercial paper program and general corporate purposes. The two CLOCs are from a consortium of thirty-one banks and expire in August 2010. These lines are subject to various affirmative and negative covenants, including a minimum net worth covenant. These CLOCs were undrawn at January 31, 2006. |
We obtained an additional $900.0 million line of credit for the period of January 3 to February 24, 2006 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. The balance outstanding on this facility at January 31, 2006 was $550.0 million.
As a result of our failure to file this Form 10-Q by the SEC’s prescribed due date, we will be unable to issue any debt securities under our shelf registration statement for a period of twelve calendar months after the month of our filing.
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. We defer all revenues and direct costs associated with these guarantees, recognizing
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these amounts over the term of the guarantee based upon historic and actual payment of claims. Changes in the deferred revenue liability are as follows:
(in 000s) | ||||||||
Nine months ended January 31, | 2006 | 2005 | ||||||
Balance, beginning of period | $ | 130,762 | $ | 123,048 | ||||
Amounts deferred for new guarantees issued | 20,533 | 19,925 | ||||||
Revenue recognized on previous deferrals | (55,932 | ) | (52,295 | ) | ||||
Balance, end of period | $ | 95,363 | $ | 90,678 | ||||
We have commitments to fund mortgage loans to customers as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. The commitments to fund loans amounted to $2.9 billion and $3.9 billion at January 31, 2006 and April 30, 2005, respectively. Of these commitments, $697.3 million and $947.5 million are considered binding commitments as of January 31, 2006 and April 30, 2005, 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 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 $40.9 million and $41.2 million at January 31, 2006 and April 30, 2005, 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 by the Trusts to satisfy their payment obligations. No losses have been sustained on this commitment since its inception. The total principal amount of Trust obligations outstanding as of January 31, 2006 and April 30, 2005 was $11.2 billion and $6.7 billion, respectively. The fair value of mortgage loans held by the Trusts as of January 31, 2006 and April 30, 2005 was $11.4 billion and $6.8 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 $13.8 million and $5.1 million as of January 31, 2006 and April 30, 2005, 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, 2006 and April 30, 2005 totaled $75.9 million and $68.9 million, respectively. We have a receivable of $60.2 million and $39.0 million, which represents the amounts drawn on the FELCs, as of January 31, 2006 and April 30, 2005, respectively.
We routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees, including obligations to protect counterparties 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, 2006.
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12. | Litigation Commitments and Contingencies | |
We have been involved in a number of class actions and putative class action cases since 1990, as well as a state attorney general lawsuit, 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 have settled others. On December 21, 2005, we entered into a settlement agreement regarding four RAL cases, subject to final court approval. Pursuant to the terms of this settlement agreement, we will contribute a total of up to $62.5 million in cash for purposes of making payments to the settlement class, paying all attorneys’ fees and costs to class counsel and covering service awards to the representative plaintiffs. In addition, we will pay costs for providing notice of the settlement to settlement class members. We recorded a reserve of $52.2 million related to this settlement in our third quarter. Two RAL class action cases and the state attorney general lawsuit are still pending, with the amounts claimed on a collective basis being very substantial. The ultimate cost of this litigation could be substantial, and in March 2006, we increased our reserves as of January 31, 2006 by an additional $19.5 million related to one of the other RAL cases. We intend to continue defending the other RAL cases vigorously, although there are no assurances as to their outcome. |
We are also a party to claims and lawsuits pertaining to our electronic tax return filing services, our POM guarantee program, and our Express IRA product. 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. In addition we are party to two shareholder derivative actions stemming from our recent financial restatement as well as separate putative class actions alleging violations of certain securities laws. 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, employment matters and civil actions, arbitrations, regulatory inquiries and class actions arising out of our business as a broker-dealer and provider of investment products and as a servicer of mortgage loans. We believe we have meritorious defenses to each of the Other Claims and Lawsuits and are defending them vigorously. Although we cannot provide assurance we will ultimately prevail in each instance, we believe that amounts, if any, required to be paid 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 attention and time, 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 separately from the corresponding litigation reserve, and only if recovery is determined to be probable. Receivables for insurance recoveries at January 31, 2006 were immaterial.
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13. | Segment Information | |
Information concerning our operations by reportable operating segment is as follows: |
(in 000s) | ||||||||||||||||
Three months ended January 31, | Nine months ended January 31, | |||||||||||||||
Restated | Restated | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Revenues: | ||||||||||||||||
Tax Services | $ | 548,494 | $ | 531,086 | $ | 686,498 | $ | 655,639 | ||||||||
Mortgage Services | 296,493 | 308,872 | 943,082 | 865,177 | ||||||||||||
Business Services | 235,840 | 132,872 | 529,491 | 371,021 | ||||||||||||
Investment Services | 73,176 | 62,104 | 211,177 | 169,446 | ||||||||||||
Corporate | 2,744 | 1,302 | 6,535 | 3,457 | ||||||||||||
$ | 1,156,747 | $ | 1,036,236 | $ | 2,376,783 | $ | 2,064,740 | |||||||||
Pretax income (loss): | ||||||||||||||||
Tax Services | $ | (6,332 | ) | $ | 63,655 | $ | (293,702 | ) | $ | (182,923 | ) | |||||
Mortgage Services | 67,453 | 115,483 | 248,160 | 332,980 | ||||||||||||
Business Services | (1,035 | ) | 5,916 | (9,943 | ) | (9,021 | ) | |||||||||
Investment Services | (7,668 | ) | (19,775 | ) | (23,126 | ) | (60,882 | ) | ||||||||
Corporate | (27,010 | ) | (12,001 | ) | (74,979 | ) | (65,494 | ) | ||||||||
Income (loss) before taxes | $ | 25,408 | $ | 153,278 | $ | (153,590 | ) | $ | 14,660 | |||||||
Pretax results from our Tax Services segment for the three and nine months ended January 31, 2006 includes a $71.7 million provision for legal reserves and related litigation fees, as discussed in note 12.
14. | New Accounting Pronouncements | |
In February 2006, Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Instruments” (SFAS 155), an amendment of FASB Statements No. 133 and 140, was issued. The provisions of this standard allow financial instruments that have embedded derivatives to be accounted for as a whole if the holder elects to account for the whole instrument on a fair value basis, and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. The new standard also amends Statement 140 to eliminate the prohibition on a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. The provisions of this standard are effective as of the beginning of our fiscal year 2008. Our residual interests typically have interests in derivative instruments embedded within the securitization trusts. If we elect to account for our residual interests on a fair value basis, changes in fair value will impact earnings in the period in which the change occurs. We are currently evaluating what effect the adoption of SFAS 155 will have on our consolidated financial statements. |
In March 2006, Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets — An Amendment of FASB Statement No. 140,” (SFAS 156), was issued. The provisions of this standard require mortgage servicing rights to be initially valued at fair value. SFAS 156 also allows servicers to choose to measure their servicing rights at fair value or to continue using the “amortization method” under SFAS 140. The provisions of this standard are effective as of the beginning of our fiscal year 2008. We are currently evaluating what effect the adoption of SFAS 156 will have on our consolidated financial statements.
Exposure Draft — Amendment of SFAS 140
In August 2005, the Financial Accounting Standards Board (FASB) issued an exposure draft which amends Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”
This exposure draft seeks to clarify the derecognition requirements for financial assets and the initial measurement of interests related to transferred financial assets that are held by a transferor. Our current off-balance sheet warehouse facilities (the Trusts) in our Mortgage Services segment would be required to be consolidated in our financial statements based on the provisions of the
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exposure draft. We will continue to monitor the status of the exposure draft and consider what changes, if any, could be made to the structure of the Trusts to continue to derecognize mortgage loans transferred to the Trusts. At January 31, 2006, the Trusts held loans totaling $11.2 billion, which we would be required to consolidate into our financial statements under the provisions of this exposure draft.
The final standard for this exposure draft is scheduled to be issued in the second quarter of calendar year 2006.
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 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. |
Condensed Consolidating Income Statements | (in 000s) | |||||||||||||||||||
Three months ended | H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||
January 31, 2006 | (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||
Total revenues | $ | — | $ | 492,631 | $ | 667,754 | $ | (3,638 | ) | $ | 1,156,747 | |||||||||
Cost of services | — | 136,863 | 497,035 | 29 | 633,927 | |||||||||||||||
Cost of other revenues | — | 124,037 | 20,626 | — | 144,663 | |||||||||||||||
Selling, general and administrative | — | 127,185 | 220,728 | (3,667 | ) | 344,246 | ||||||||||||||
Total expenses | — | 388,085 | 738,389 | (3,638 | ) | 1,122,836 | ||||||||||||||
Operating income (loss) | — | 104,546 | (70,635 | ) | — | 33,911 | ||||||||||||||
Interest expense | — | 11,810 | 401 | — | 12,211 | |||||||||||||||
Other income, net | 25,408 | — | 3,708 | (25,408 | ) | 3,708 | ||||||||||||||
Income (loss) before taxes | 25,408 | 92,736 | (67,328 | ) | (25,408 | ) | 25,408 | |||||||||||||
Income taxes (benefit) | 13,295 | 37,505 | (24,210 | ) | (13,295 | ) | 13,295 | |||||||||||||
Net income (loss) | $ | 12,113 | $ | 55,231 | $ | (43,118 | ) | $ | (12,113 | ) | $ | 12,113 | ||||||||
Three months ended | H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||
January 31, 2005 (Restated) | (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||
Total revenues | $ | — | $ | 446,508 | $ | 593,396 | $ | (3,668 | ) | $ | 1,036,236 | |||||||||
Cost of services | — | 104,561 | 403,715 | (69 | ) | 508,207 | ||||||||||||||
Cost of other revenues | — | 114,759 | 18,584 | — | 133,343 | |||||||||||||||
Selling, general and administrative | — | 91,939 | 159,774 | (3,599 | ) | 248,114 | ||||||||||||||
Total expenses | — | 311,259 | 582,073 | (3,668 | ) | 889,664 | ||||||||||||||
Operating income (loss) | — | 135,249 | 11,323 | — | 146,572 | |||||||||||||||
Interest expense | — | 12,180 | 846 | — | 13,026 | |||||||||||||||
Other income, net | 153,278 | — | 19,732 | (153,278 | ) | 19,732 | ||||||||||||||
Income before taxes | 153,278 | 123,069 | 30,209 | (153,278 | ) | 153,278 | ||||||||||||||
Income taxes | 59,542 | 54,578 | 4,964 | (59,542 | ) | 59,542 | ||||||||||||||
Net income | $ | 93,736 | $ | 68,491 | $ | 25,245 | $ | (93,736 | ) | $ | 93,736 | |||||||||
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Nine months ended | H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||
January 31, 2006 | (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||
Total revenues | $ | — | $ | 1,349,096 | $ | 1,038,594 | $ | (10,907 | ) | $ | 2,376,783 | |||||||||
Cost of service revenues | — | 362,034 | 1,002,167 | 161 | 1,364,362 | |||||||||||||||
Cost of other revenues | — | 374,253 | 28,631 | — | 402,884 | |||||||||||||||
Selling, general and administrative | — | 315,333 | 435,782 | (11,068 | ) | 740,047 | ||||||||||||||
Total expenses | — | 1,051,620 | 1,466,580 | (10,907 | ) | 2,507,293 | ||||||||||||||
Operating income (loss) | — | 297,476 | (427,986 | ) | — | (130,510 | ) | |||||||||||||
Interest expense | — | 35,431 | 1,600 | — | 37,031 | |||||||||||||||
Other income, net | (153,590 | ) | — | 13,951 | 153,590 | 13,951 | ||||||||||||||
Income (loss) before taxes | (153,590 | ) | 262,045 | (415,635 | ) | 153,590 | (153,590 | ) | ||||||||||||
Income taxes (benefit) | (56,460 | ) | 103,536 | (159,996 | ) | 56,460 | (56,460 | ) | ||||||||||||
Net income (loss) | $ | (97,130 | ) | $ | 158,509 | $ | (255,639 | ) | $ | 97,130 | $ | (97,130 | ) | |||||||
Nine months ended | H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||
January 31, 2005 (Restated) | (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||
Total revenues | $ | — | $ | 1,115,976 | $ | 959,051 | $ | (10,287 | ) | $ | 2,064,740 | |||||||||
Cost of services | — | 291,531 | 831,695 | 40 | 1,123,266 | |||||||||||||||
Cost of other revenues | — | 282,504 | 25,483 | — | 307,987 | |||||||||||||||
Selling, general and administrative | — | 235,581 | 367,923 | (10,327 | ) | 593,177 | ||||||||||||||
Total expenses | — | 809,616 | 1,225,101 | (10,287 | ) | 2,024,430 | ||||||||||||||
Operating income (loss) | — | 306,360 | (266,050 | ) | — | 40,310 | ||||||||||||||
Interest expense | — | 46,330 | 2,570 | — | 48,900 | |||||||||||||||
Other income, net | 14,660 | — | 23,250 | (14,660 | ) | 23,250 | ||||||||||||||
Income (loss) before taxes | 14,660 | 260,030 | (245,370 | ) | (14,660 | ) | 14,660 | |||||||||||||
Income taxes (benefit) | 5,680 | 108,061 | (102,381 | ) | (5,680 | ) | 5,680 | |||||||||||||
Net income (loss) | $ | 8,980 | $ | 151,969 | $ | (142,989 | ) | $ | (8,980 | ) | $ | 8,980 | ||||||||
Condensed Consolidating Balance Sheets |
(in 000s) | |||||||||||||||||||||
H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
January 31, 2006 | (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | ||||||||||||||||
Cash & cash equivalents | $ | — | $ | 286,226 | $ | 1,173,954 | $ | — | $ | 1,460,180 | |||||||||||
Cash & cash equivalents — restricted | — | 424,115 | 6,598 | — | 430,713 | ||||||||||||||||
Receivables from customers, brokers and dealers, net | — | 569,430 | — | — | 569,430 | ||||||||||||||||
Receivables, net | 747 | 1,316,571 | 493,627 | — | 1,810,945 | ||||||||||||||||
Intangible assets and goodwill, net | — | 396,397 | 943,106 | — | 1,339,503 | ||||||||||||||||
Investments in subsidiaries | 4,685,740 | 219 | 521 | (4,685,740 | ) | 740 | |||||||||||||||
Other assets | — | 1,613,833 | 447,023 | (26 | ) | 2,060,830 | |||||||||||||||
Total assets | $ | 4,686,487 | $ | 4,606,791 | $ | 3,064,829 | $ | (4,685,766 | ) | $ | 7,672,341 | ||||||||||
Commercial paper | $ | — | $ | 2,575,756 | $ | 20,192 | $ | — | $ | 2,595,948 | |||||||||||
Accts. payable to customers, brokers and dealers | — | 851,827 | — | — | 851,827 | ||||||||||||||||
Long-term debt | — | 897,217 | 19,709 | — | 916,926 | ||||||||||||||||
Other liabilities | 2 | 600,609 | 1,119,076 | — | 1,719,687 | ||||||||||||||||
Net intercompany advances | 3,098,532 | (1,976,900 | ) | (1,121,606 | ) | (26 | ) | — | |||||||||||||
Stockholders’ equity | 1,587,953 | 1,658,282 | 3,027,458 | (4,685,740 | ) | 1,587,953 | |||||||||||||||
Total liabilities and stockholders’ equity | $ | 4,686,487 | $ | 4,606,791 | $ | 3,064,829 | $ | (4,685,766 | ) | $ | 7,672,341 | ||||||||||
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H&R Block, Inc. | BFC | Other | Consolidated | |||||||||||||||||
April 30, 2005 (Restated) | (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||
Cash & cash equivalents | $ | — | $ | 162,983 | $ | 937,230 | $ | — | $ | 1,100,213 | ||||||||||
Cash & cash equivalents — restricted | — | 488,761 | 28,148 | — | 516,909 | |||||||||||||||
Receivables from customers, brokers and dealers, net | — | 590,226 | — | — | 590,226 | |||||||||||||||
Receivables, net | 101 | 199,990 | 218,697 | — | 418,788 | |||||||||||||||
Intangible assets and goodwill, net | — | 421,036 | 842,003 | — | 1,263,039 | |||||||||||||||
Investments in subsidiaries | 4,851,680 | 210 | 449 | (4,851,680 | ) | 659 | ||||||||||||||
Other assets | — | 1,407,082 | 241,532 | (392 | ) | 1,648,222 | ||||||||||||||
Total assets | $ | 4,851,781 | $ | 3,270,288 | $ | 2,268,059 | $ | (4,852,072 | ) | $ | 5,538,056 | |||||||||
Accts. payable to customers, brokers and dealers | $ | — | $ | 950,684 | $ | — | $ | — | $ | 950,684 | ||||||||||
Long-term debt | — | 896,591 | 26,482 | — | 923,073 | |||||||||||||||
Other liabilities | 2 | 532,562 | 1,182,459 | 8 | 1,715,031 | |||||||||||||||
Net intercompany advances | 2,902,511 | (641,611 | ) | (2,262,818 | ) | 1,918 | — | |||||||||||||
Stockholders’ equity | 1,949,268 | 1,532,062 | 3,321,936 | (4,853,998 | ) | 1,949,268 | ||||||||||||||
Total liabilities and stockholders’ equity | $ | 4,851,781 | $ | 3,270,288 | $ | 2,268,059 | $ | (4,852,072 | ) | $ | 5,538,056 | |||||||||
Condensed Consolidating Statements of Cash Flows
(in 000s) | ||||||||||||||||||||
Nine months ended | H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||
January 31, 2006 | (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||
Net cash provided by (used in) operating activities: | $ | 43,228 | $ | (1,193,527 | ) | $ | (539,248 | ) | $ | — | $ | (1,689,547 | ) | |||||||
Cash flows from investing: | ||||||||||||||||||||
Cash received on residuals | — | 74,931 | — | — | 74,931 | |||||||||||||||
Cash received on sale of residuals | — | 30,497 | — | — | 30,497 | |||||||||||||||
Purchase property & equipment | — | (31,627 | ) | (135,554 | ) | — | (167,181 | ) | ||||||||||||
Payments for business acquisitions | — | (3,140 | ) | (206,676 | ) | — | (209,816 | ) | ||||||||||||
Net intercompany advances | 229,755 | — | — | (229,755 | ) | — | ||||||||||||||
Other, net | — | — | 17,297 | — | 17,297 | |||||||||||||||
Net cash provided by (used in) investing activities | 229,755 | 70,661 | (324,933 | ) | (229,755 | ) | (254,272 | ) | ||||||||||||
Cash flows from financing: | ||||||||||||||||||||
Repayments of commercial paper | — | (2,610,432 | ) | (22,012 | ) | — | (2,632,444 | ) | ||||||||||||
Proceeds from commercial paper | — | 4,636,188 | 42,204 | — | 4,678,392 | |||||||||||||||
Proceeds from short-term borrowings | — | 550,000 | — | — | 550,000 | |||||||||||||||
Dividends paid | (118,665 | ) | — | — | — | (118,665 | ) | |||||||||||||
Acquisition of treasury shares | (260,078 | ) | — | — | — | (260,078 | ) | |||||||||||||
Proceeds from common stock | 105,760 | — | — | — | 105,760 | |||||||||||||||
Net intercompany advances | — | (1,335,289 | ) | 1,105,534 | 229,755 | — | ||||||||||||||
Other, net | — | 5,642 | (24,821 | ) | — | (19,179 | ) | |||||||||||||
Net cash provided by (used in) financing activities | (272,983 | ) | 1,246,109 | 1,100,905 | 229,755 | 2,303,786 | ||||||||||||||
Net increase in cash | — | 123,243 | 236,724 | — | 359,967 | |||||||||||||||
Cash — beginning of period | — | 162,983 | 937,230 | — | 1,100,213 | |||||||||||||||
Cash — end of period | $ | — | $ | 286,226 | $ | 1,173,954 | $ | — | $ | 1,460,180 | ||||||||||
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Nine months ended | H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||
January 31, 2005 (Restated) | (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||
Net cash provided by (used in) operating activities: | $ | 16,683 | $ | (840,959 | ) | $ | (740,157 | ) | $ | — | $ | (1,564,433 | ) | |||||||
Cash flows from investing: | ||||||||||||||||||||
Cash received on residuals | — | 100,344 | — | — | 100,344 | |||||||||||||||
Purchase property & equipment | — | (28,104 | ) | (115,128 | ) | — | (143,232 | ) | ||||||||||||
Payments for business acquisitions | — | — | (26,348 | ) | — | (26,348 | ) | |||||||||||||
Net intercompany advances | 499,699 | — | — | (499,699 | ) | — | ||||||||||||||
Other, net | — | (152 | ) | 15,359 | — | 15,207 | ||||||||||||||
Net cash provided by (used in) investing activities | 499,699 | 72,088 | (126,117 | ) | (499,699 | ) | (54,029 | ) | ||||||||||||
Cash flows from financing: | ||||||||||||||||||||
Repayments of commercial paper | — | (2,348,966 | ) | — | — | (2,348,966 | ) | |||||||||||||
Proceeds from commercial paper | — | 3,857,750 | 20,098 | — | 3,877,848 | |||||||||||||||
Repayments of long-term debt | — | (250,000 | ) | — | — | (250,000 | ) | |||||||||||||
Proceeds from long-term debt | — | 395,221 | — | — | 395,221 | |||||||||||||||
Dividends paid | (106,422 | ) | — | — | — | (106,422 | ) | |||||||||||||
Acquisition of treasury shares | (529,852 | ) | — | — | — | (529,852 | ) | |||||||||||||
Proceeds from common stock | 119,892 | — | — | — | 119,892 | |||||||||||||||
Net intercompany advances | — | (880,648 | ) | 380,949 | 499,699 | — | ||||||||||||||
Other, net | — | — | (35,414 | ) | — | (35,414 | ) | |||||||||||||
Net cash provided by (used in) financing activities | (516,382 | ) | 773,357 | 365,633 | 499,699 | 1,122,307 | ||||||||||||||
Net increase (decrease) in cash | — | 4,486 | (500,641 | ) | — | (496,155 | ) | |||||||||||||
Cash — beginning of period | — | 133,188 | 939,557 | — | 1,072,745 | |||||||||||||||
Cash — end of period | $ | — | $ | 137,674 | $ | 438,916 | $ | — | $ | 576,590 | ||||||||||
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ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
RESULTS OF OPERATIONS
H&R Block is a diversified company delivering tax services and financial advice, investment and mortgage services, and business and consulting services. For 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), together with its attest-firm affiliations, is the fifth largest national accounting, tax and consulting firm primarily serving mid-sized businesses.
Our Mission
To help our clients achieve their financial objectives
by serving as their tax and financial partner.
To help our clients achieve their financial objectives
by 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 accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations reflects the restatements of previously issued financial statements, as discussed in note 2 to our condensed consolidated financial statements. The analysis that follows should be read in conjunction with the tables below and the condensed consolidated income statements found on page 2.
Consolidated H&R Block, Inc. — Operating Results
(in 000s, except per share amounts) | ||||||||||||||||
Three months ended January 31, | Nine months ended January 31, | |||||||||||||||
Restated | Restated | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Revenues: | ||||||||||||||||
Tax Services | $ | 548,494 | $ | 531,086 | $ | 686,498 | $ | 655,639 | ||||||||
Mortgage Services | 296,493 | 308,872 | 943,082 | 865,177 | ||||||||||||
Business Services | 235,840 | 132,872 | 529,491 | 371,021 | ||||||||||||
Investment Services | 73,176 | 62,104 | 211,177 | 169,446 | ||||||||||||
Corporate | 2,744 | 1,302 | 6,535 | 3,457 | ||||||||||||
$ | 1,156,747 | $ | 1,036,236 | $ | 2,376,783 | $ | 2,064,740 | |||||||||
Pretax income (loss): | ||||||||||||||||
Tax Services | $ | (6,332 | ) | $ | 63,655 | $ | (293,702 | ) | $ | (182,923 | ) | |||||
Mortgage Services | 67,453 | 115,483 | 248,160 | 332,980 | ||||||||||||
Business Services | (1,035 | ) | 5,916 | (9,943 | ) | (9,021 | ) | |||||||||
Investment Services | (7,668 | ) | (19,775 | ) | (23,126 | ) | (60,882 | ) | ||||||||
Corporate | (27,010 | ) | (12,001 | ) | (74,979 | ) | (65,494 | ) | ||||||||
25,408 | 153,278 | (153,590 | ) | 14,660 | ||||||||||||
Income taxes (benefit) | 13,295 | 59,542 | (56,460 | ) | 5,680 | |||||||||||
Net income (loss) | $ | 12,113 | $ | 93,736 | $ | (97,130 | ) | $ | 8,980 | |||||||
Basic and diluted earnings (loss) per share | $ | 0.04 | $ | 0.28 | $ | (0.30 | ) | $ | 0.03 | |||||||
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TAX SERVICES
This segment primarily consists of our income tax preparation businesses — retail, online and software.
Tax Services — Operating Statistics (U.S. only)
Period January 1 through January 31, | ||||||||
2006 | 2005 | |||||||
Clients served (in 000s): | ||||||||
Company-owned operations | 2,372 | 2,447 | ||||||
Franchise operations | 1,398 | 1,406 | ||||||
3,770 | 3,853 | |||||||
Average fee per client served:(1) | ||||||||
Company-owned operations | $ | 160.19 | $ | 149.94 | ||||
Franchise operations | 137.06 | 130.82 | ||||||
$ | 151.61 | $ | 142.97 | |||||
Refund anticipation loans (RALs) (in 000s): | ||||||||
Company-owned operations | 1,149 | 1,197 | ||||||
Franchise operations | 716 | 714 | ||||||
1,865 | 1,911 | |||||||
Offices: | ||||||||
Company-owned | 6,387 | 5,811 | ||||||
Company-owned shared locations(2) | 1,473 | 1,296 | ||||||
Total company-owned offices | 7,860 | 7,107 | ||||||
Franchise | 3,703 | 3,528 | ||||||
Franchise shared locations(2) | 602 | 526 | ||||||
Total franchise offices | 4,305 | 4,054 | ||||||
12,165 | 11,161 | |||||||
(1) | Calculated as tax preparation and related fees divided by clients served. | |
(2) | Shared locations include offices located within Wal-Mart, Sears and other third-party businesses. |
Tax Services — Operating Results
(in 000s) | ||||||||||||||||
Three months ended January 31, | Nine months ended January 31, | |||||||||||||||
Restated | Restated | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Service revenues: | ||||||||||||||||
Tax preparation and related fees | $ | 389,040 | $ | 375,346 | $ | 452,862 | $ | 428,323 | ||||||||
Online tax services | 7,057 | 10,739 | 8,310 | 12,048 | ||||||||||||
Other services | 25,459 | 23,623 | 85,437 | 76,682 | ||||||||||||
421,556 | 409,708 | 546,609 | 517,053 | |||||||||||||
Royalties | 53,706 | 50,920 | 60,263 | 56,271 | ||||||||||||
RAL participation fees | 42,616 | 43,354 | 42,893 | 43,520 | ||||||||||||
Software sales | 16,914 | 18,072 | 19,123 | 20,779 | ||||||||||||
Other | 13,702 | 9,032 | 17,610 | 18,016 | ||||||||||||
Total revenues | 548,494 | 531,086 | 686,498 | 655,639 | ||||||||||||
Cost of services: | ||||||||||||||||
Compensation and benefits | 193,410 | 184,282 | 283,562 | 258,205 | ||||||||||||
Occupancy | 79,516 | 74,951 | 201,112 | 178,078 | ||||||||||||
Depreciation | 11,132 | 14,908 | 31,629 | 33,522 | ||||||||||||
Other | 51,030 | 53,385 | 123,965 | 122,734 | ||||||||||||
335,088 | 327,526 | 640,268 | 592,539 | |||||||||||||
Cost of software sales | 10,864 | 13,248 | 17,601 | 20,400 | ||||||||||||
Provision for RAL litigation | 71,700 | — | 71,700 | — | ||||||||||||
Selling, general and administrative | 137,174 | 126,657 | 250,631 | 225,623 | ||||||||||||
Total expenses | 554,826 | 467,431 | 980,200 | 838,562 | ||||||||||||
Pretax income (loss) | $ | (6,332 | ) | $ | 63,655 | $ | (293,702 | ) | $ | (182,923 | ) | |||||
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Three months ended January 31, 2006 compared to January 31, 2005
Tax Services’ revenues increased $17.4 million, or 3.3%, for the three months ended January 31, 2006 compared to the prior year.
Tax preparation and related fees increased $13.7 million, or 3.6%, for the current quarter. This increase is primarily due to an increase of 6.8% in the average fee per U.S. client served, partially offset by a decrease of 3.2% in U.S. clients served in company-owned offices. The decrease in clients served was partially due to a number of technology problems that severely hurt the start of our filing season coupled with increased competition due to competitors’ refund lending products.
Online tax service revenue declined $3.7 million, or 34.3%, primarily due to planned reductions in unit prices.
Royalty revenue increased $2.8 million, or 5.5%, due to a 4.8% increase in the average fee slightly offset by a 0.4% decline in clients served in franchise offices.
Other revenues increased $4.7 million primarily due to an increase in supply sales to franchises during the current quarter.
Total expenses increased $87.4 million, or 18.7%, primarily due to $71.7 million of legal reserves and related litigation fees recorded in the current period. During the current quarter we entered into a settlement agreement regarding four separate RAL cases covering 22 states. As a result of this settlement agreement, we recorded a pretax charge of $52.2 million, or $0.10 per diluted share, for the unreserved cost of the proposed litigation settlement and related fees. In March 2006, we engaged in settlement negotiations with plaintiffs in another RAL case and accordingly increased our reserves as of January 31, 2006 and recorded a pretax charge of $19.5 million. See additional discussion below and in note 12 to the condensed consolidated financial statements.
Cost of services for the three months ended January 31, 2006 increased $7.6 million, or 2.3%, from the prior year. Our real estate expansion efforts have contributed to a total increase of $13.0 million across all cost of services categories. Compensation and benefits increased $9.1 million, or 5.0%, primarily due to an increase in staff needed for our new offices and the addition of costs related to our small business initiatives in the current year. Occupancy expenses increased $4.6 million, or 6.1%, primarily as a result of higher rent expenses, due to a 9.6% increase in company-owned offices under lease and a 7.5% increase in the average rent. Depreciation declined $3.8 million, or 25.3%, primarily due to decreased capital expenditures compared to the prior year and the timing of certain depreciation expenses. Other cost of services declined $2.4 million, or 4.4%, due to a decline of $3.4 million in corporate shared services and lower expenses associated with our POM guarantee, partially offset by an increase of $3.8 million in supplies expenses.
Selling, general and administrative expenses increased $10.5 million, or 8.3%, primarily due to a $9.7 million increase in corporate shared services, $6.6 million of which was related to our marketing efforts. We also incurred higher costs associated with increased supply sales to franchises and additional costs related to our small business initiatives in the current year.
The pretax loss was $6.3 million for the three months ended January 31, 2006 compared to income of $63.7 million in the prior year.
Due to the seasonal nature of this segment’s business, operating results for the three months ended January 31, 2006 are not comparable to the three months ended October 31, 2005 and are not indicative of the expected results for the entire fiscal year.
Nine months ended January 31, 2006 compared to January 31, 2005
Tax Services’ revenues increased $30.9 million, or 4.7%, for the nine months ended January 31, 2006 compared to the prior year.
Tax preparation and related fees increased $24.5 million, or 5.7%, primarily due to an increase in the average fee per U.S. client served, partially offset by a decrease in U.S. clients served in company-owned offices during the first month of the tax season. Improved performance during the Australian and Canadian tax seasons also contributed $3.0 million and $2.6 million, respectively, of additional tax preparation revenues in the current year.
Online tax service revenue declined $3.7 million, or 31.0%, primarily due to planned reductions in unit prices.
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Other service revenues increased $8.8 million primarily as a result of additional revenues associated with POM guarantees and our small business initiatives.
Royalty revenue increased $4.0 million, or 7.1%, due to an increase in the average fee slightly offset by a slight decline in clients served in franchise offices.
Total expenses increased $141.6 million, or 16.9%, primarily due to $71.7 million of legal reserves and related litigation fees recorded in the current period. Cost of services for the nine months ended January 31, 2006 increased $47.7 million, or 8.1%, from the prior year. Our real estate expansion efforts have contributed to a total increase of $29.0 million across all cost of services categories.
Compensation and benefits increased $25.4 million primarily due to an increase in the staff needed for our new offices, payroll taxes and the addition of costs related to our small business initiatives. Occupancy expenses increased $23.0 million, or 12.9%, primarily as a result of higher rent expenses, due to an 8.9% increase in company-owned offices under lease and an 8.5% increase in the average rent. Utilities and real estate taxes also contributed to the increase.
Selling, general and administrative expenses increased $25.0 million, or 11.1%, over the prior year primarily due to $13.1 million in additional costs from corporate shared services, $7.6 million of which was related to our marketing efforts. We also incurred $4.1 million in additional legal expenses and $6.0 million in additional corporate wages.
The pretax loss was $293.7 million for the nine months ended January 31, 2006 compared to a prior year loss of $182.9 million.
Fiscal 2006 outlook
Our fiscal year 2006 outlook for the Tax Services segment has not changed materially from the discussion in our April 30, 2005 Form 10-K/A. As part of our real estate expansion, we opened 550 new company-owned offices and 184 new franchise offices in the current tax season, exceeding our goal to open between 500 and 700 company-owned and franchise offices this year.
RAL Litigation
On December 21, 2005, we entered into a settlement agreement regarding litigation pertaining to our RAL programs entitledDeadra D. Cummins, et al.v. H&R Block,Inc. et al.;Mitchell v. H&R Block, Inc. et al.; Green v. H&R Block, Inc. et al.;andBecker v. H&R Block, Inc.(the “Settlement Agreement”).The Settlement Agreement is subject to final court approval. Pursuant to the Settlement Agreement’s terms, we will contribute a total of up to $62.5 million in cash for purposes of making payments to the settlement class, paying all attorneys’ fees and costs to class counsel, and covering service awards to the representative plaintiffs. In addition, we will pay costs for providing notice of the settlement to settlement class members. We recorded a reserve of $52.2 million related to this settlement in our third quarter.
We are named as a defendant in two other class-action lawsuits and one state attorney general lawsuit alleging that we engaged in wrongdoing with respect to the RAL program. In March 2006, we engaged in settlement negotiations with the plaintiffs in one of these RAL cases and accordingly increased our reserves as of January 31, 2006 by $19.5 million. We believe we have strong defenses to the other lawsuits and will vigorously defend our position. Nevertheless, the amounts claimed in these lawsuits are, in some instances, very substantial, and there can be no assurances as to their ultimate outcome, or as to their impact 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.”
MORTGAGE SERVICES
This segment is primarily engaged in the origination of non-prime mortgage loans through an independent broker network, the origination of prime and non-prime mortgage loans through a retail office network, the sale and securitization of mortgage loans and residual interests, and the servicing of non-prime loans.
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Mortgage Services — Operating Statistics
(dollars in 000s) | ||||||||||||
Restated | ||||||||||||
Three months ended | January 31, 2006 | January 31, 2005 | October 31, 2005 | |||||||||
Volume of loans originated: | ||||||||||||
Wholesale (non-prime) | $ | 7,941,048 | $ | 7,378,071 | $ | 11,078,960 | ||||||
Retail: Non-prime | 667,542 | 776,797 | 1,111,924 | |||||||||
Prime | 343,897 | 238,867 | 429,924 | |||||||||
$ | 8,952,487 | $ | 8,393,735 | $ | 12,620,808 | |||||||
Loan characteristics: | ||||||||||||
Weighted average FICO score(1) | 621 | 615 | 629 | |||||||||
Weighted average interest rate for borrowers(1) | 8.27 | % | 7.30 | % | 7.48 | % | ||||||
Weighted average loan-to-value(1) | 80.0 | % | 79.3 | % | 80.6 | % | ||||||
Origination margin (% of origination volume):(2) | ||||||||||||
Loan sale premium | 1.43 | % | 2.42 | % | 0.55 | % | ||||||
Residual cash flows from beneficial interest in Trusts | 0.81 | % | 0.57 | % | 0.41 | % | ||||||
Gain on derivative instruments | 0.06 | % | 0.37 | % | 0.48 | % | ||||||
Loan sale repurchase reserves | (0.15 | %) | (0.14 | %) | (0.16 | %) | ||||||
Retained mortgage servicing rights | 0.67 | % | 0.43 | % | 0.69 | % | ||||||
2.82 | % | 3.65 | % | 1.97 | % | |||||||
Cost of acquisition | (0.27 | %) | (0.60 | %) | (0.40 | %) | ||||||
Direct origination expenses | (0.69 | %) | (0.63 | %) | (0.56 | %) | ||||||
Net gain on sale — gross margin(3) | 1.86 | % | 2.42 | % | 1.01 | % | ||||||
Other revenues | (0.04 | %) | 0.03 | % | 0.02 | % | ||||||
Other cost of origination | (1.43 | %) | (1.47 | %) | (1.23 | %) | ||||||
Net margin | 0.39 | % | 0.98 | % | (0.20 | %) | ||||||
Total cost of origination | 2.12 | % | 2.10 | % | 1.79 | % | ||||||
Total cost of origination and acquisition | 2.39 | % | 2.70 | % | 2.19 | % | ||||||
Loan delivery: | ||||||||||||
Loan sales | $ | 8,924,788 | $ | 8,348,537 | $ | 12,497,526 | ||||||
Execution price(4) | 0.51 | % | 2.82 | % | 1.63 | % |
(1) | Represents non-prime production. | |
(2) | See “Reconciliation of Non-GAAP Financial Information” on page 44. | |
(3) | Defined as gain on sale of mortgage loans (including gain or loss on derivatives, mortgage servicing rights and net of direct origination and acquisition expenses) divided by origination volume. | |
(4) | Defined as total premium received divided by total balance of loans delivered to third-party investors or securitization vehicles (excluding mortgage servicing rights and the effect of loan origination expenses). |
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Mortgage Services — Operating Results
(in 000s) | ||||||||||||
Restated | ||||||||||||
Three months ended | January 31, 2006 | January 31, 2005 | October 31, 2005 | |||||||||
Components of gains on sales: | ||||||||||||
Gain on mortgage loans | $ | 161,399 | $ | 172,381 | $ | 66,580 | ||||||
Gain (loss) on derivatives | 5,060 | 30,756 | 60,750 | |||||||||
Gain on sales of residual interests | — | — | 28,675 | |||||||||
Impairment of residual interests | (8,562 | ) | (4,553 | ) | (8,738 | ) | ||||||
157,897 | 198,584 | 147,267 | ||||||||||
Interest income: | ||||||||||||
Accretion — residual interests | 28,849 | 32,728 | 33,564 | |||||||||
Other interest income | 3,464 | 4,064 | 4,605 | |||||||||
32,313 | 36,792 | 38,169 | ||||||||||
Loan servicing revenue | 106,065 | 72,928 | 100,386 | |||||||||
Other | 218 | 568 | 329 | |||||||||
Total revenues | 296,493 | 308,872 | 286,151 | |||||||||
Cost of services | 83,076 | 56,766 | 67,811 | |||||||||
Cost of other revenues: | ||||||||||||
Compensation and benefits | 70,647 | 64,100 | 84,151 | |||||||||
Occupancy | 9,169 | 9,546 | 10,531 | |||||||||
Other | 24,682 | 18,698 | 28,737 | |||||||||
104,498 | 92,344 | 123,419 | ||||||||||
Selling, general and administrative | 41,466 | 44,279 | 48,682 | |||||||||
Total expenses | 229,040 | 193,389 | 239,912 | |||||||||
Pretax income | $ | 67,453 | $ | 115,483 | $ | 46,239 | ||||||
Three months ended January 31, 2006 compared to January 31, 2005
Mortgage Services’ revenues decreased $12.4 million, or 4.0%, for the three months ended January 31, 2006 compared to the prior year. Revenues decreased as a result of lower margins on mortgage loans sold and a decline in gains on derivatives, partially offset by higher loan servicing revenue.
The following table summarizes the key drivers of gains on sales of mortgage loans:
(dollars in 000s) | ||||||||
Three months ended January 31, | 2006 | 2005 | ||||||
Application process: | ||||||||
Total number of applications | 75,103 | 84,810 | ||||||
Number of sales associates(1) | 3,486 | 3,523 | ||||||
Closing ratio(2) | 61.4 | % | 60.4 | % | ||||
Originations: | ||||||||
Total number of originations | 46,134 | 51,267 | ||||||
Weighted average interest rate for borrowers (WAC) | 8.27 | % | 7.30 | % | ||||
Average loan size | $ | 194 | $ | 164 | ||||
Total originations | $ | 8,952,487 | $ | 8,393,735 | ||||
Direct origination and acquisition expenses, net | $ | 85,974 | $ | 102,878 | ||||
Revenue (loan value): | ||||||||
Net gain on sale — gross margin(3) | 1.86 | % | 2.42 | % |
(1) | Includes all direct sales and back office sales support associates. | |
(2) | Percentage of loans funded divided by total applications in the period. | |
(3) | Defined as gain on sale of mortgage loans (including gain or loss on derivatives, mortgage servicing rights and net of direct origination and acquisition expenses) divided by origination volume. |
Despite a 6.7% increase in loan origination volume, gains on sales of mortgage loans decreased $11.0 million, primarily as a result of moderating demand by loan buyers and rapidly rising two-year swap rates. Market interest rates, based on the two-year swap, increased from an average of 3.39% last year to 4.83% in the current quarter. However, our WAC increased only 97 basis points, up to 8.27% from 7.30% in the prior year. Because of poor alignment of our WAC with market rates and increases in our funding costs, our gross margin declined 56 basis points, to 1.86% from 2.42% last year.
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The value of MSRs we recorded in the third quarter increased to 67 basis points from 43 basis points in the prior year, which coupled with an increase in origination volume, resulted in an increase of $24.3 million in gains on sales of mortgage loans. In the second quarter of fiscal year 2006, we completed an evaluation of the assumptions used to value our MSRs. Based on the changes in our assumptions as a result of this evaluation, the gain on sale for our retained MSRs increased by approximately 14 basis points, primarily as a result of lower servicing costs, in particular interest paid to bondholders on monthly loan prepayments. In addition, the increase in average loan size to $194,000 from $164,000 in the current quarter resulted in an approximate 8 basis point increase in the value of retained MSRs.
To mitigate the risk of short-term changes in market interest rates related to our loan originations, we use interest rate swaps and forward loan sale commitments. We generally enter into interest rate swap arrangements related to existing loan applications with rate-lock commitments and for rate-lock commitments we expect to make in the next two to three weeks. During the current quarter, we recorded a net $5.1 million in gains, compared to $30.8 million in the prior year, related to our various derivative instruments. See note 8 to the condensed consolidated financial statements.
During the current quarter, our available-for-sale residual interests performed better than expected in our internal valuation models, with lower credit losses than originally modeled, partially offset by higher interest rates. We recorded favorable pretax mark-to-market adjustments, which increased the fair value of our residual interests $16.8 million during the quarter. These adjustments were recorded, net of write-downs of $3.7 million and deferred taxes of $5.0 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests. Offsetting this increase were impairments of $8.6 million, which were recorded in gains on sales of mortgage assets. 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.
The following table summarizes the key drivers of loan servicing revenues:
(dollars in 000s) | ||||||||
Three months ended January 31, | 2006 | 2005 | ||||||
Average servicing portfolio: | ||||||||
With related MSRs | $ | 59,344,676 | $ | 41,753,865 | ||||
Without related MSRs | 21,046,638 | 15,584,677 | ||||||
$ | 80,391,314 | $ | 57,338,542 | |||||
Ending servicing portfolio: | ||||||||
With related MSRs | $ | 60,787,507 | $ | 43,642,212 | ||||
Without related MSRs | 15,994,170 | 15,342,627 | ||||||
$ | 76,781,677 | $ | 58,984,839 | |||||
Number of loans serviced | 466,026 | 387,619 | ||||||
Average delinquency rate | 5.58 | % | 5.02 | % | ||||
Weighted average FICO score | 621 | 621 | ||||||
Weighted average interest rate (WAC) of portfolio | 7.63 | % | 7.38 | % | ||||
Value of MSRs | $ | 262,369 | $ | 147,511 |
Loan servicing revenues increased $33.1 million, or 45.4%, compared to the prior year. The increase reflects a higher loan servicing portfolio resulting from our continued origination growth. The average servicing portfolio for the three months ended January 31, 2006 increased $23.1 billion, or 40.2%, to $80.4 billion. The annualized rate earned on our entire servicing portfolio was 34 basis points for the current quarter, compared to 37 basis points in the prior year.
Total expenses for the three months ended January 31, 2006, increased $35.7 million, or 18.4%, over the prior year. Cost of services increased $26.3 million as a result of a higher average servicing portfolio during the current quarter and increased amortization of MSRs.
Cost of other revenues increased $12.2 million, primarily due to $6.5 million in increased compensation and benefits as a result of an increase in the average number of sales associates during the period and origination-based incentives. Other expenses increased $6.0 million primarily as a
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result of $6.1 million in additional interest expense related to mortgage loans held on our balance sheet.
Selling, general and administrative expenses decreased $2.8 million due to a reduction in corporate staffing levels.
Pretax income decreased $48.0 million to $67.5 million for the three months ended January 31, 2006.
Three months ended January 31, 2006 compared to October 31, 2005
Mortgage Services’ revenues increased $10.3 million, or 3.6%, for the three months ended January 31, 2006, compared to the second quarter. Revenues increased primarily due to improving margins and higher loan servicing revenue, partially offset by lower gains on derivatives and a gain on sale of residual interests recorded in the second quarter.
The following table summarizes the key drivers of gains on sales of mortgage loans:
(dollars in 000s) | ||||||||
Three months ended | January 31, 2006 | October 31, 2005 | ||||||
Application process: | ||||||||
Total number of applications | 75,103 | 105,444 | ||||||
Number of sales associates(1) | 3,486 | 3,910 | ||||||
Closing ratio(2) | 61.4 | % | 63.8 | % | ||||
Originations: | ||||||||
Total number of originations | 46,134 | 67,264 | ||||||
Weighted average interest rate for borrowers (WAC) | 8.27 | % | 7.48 | % | ||||
Average loan size | $ | 194 | $ | 188 | ||||
Total originations | $ | 8,952,487 | $ | 12,620,808 | ||||
Direct origination and acquisition expenses, net | $ | 85,974 | $ | 120,981 | ||||
Revenue (loan value): | ||||||||
Net gain on sale — gross margin(3) | 1.86 | % | 1.01 | % |
(1) | Includes all direct sales and back office sales support associates. | |
(2) | Percentage of loans funded divided by total applications in the period. | |
(3) | Defined as gain on sale of mortgage loans (including gain or loss on derivatives, mortgage servicing rights and net of direct origination and acquisition expenses) divided by origination volume. |
Gains on sales of mortgage loans increased $94.8 million primarily as a result of better pricing in the market coupled with increases in our coupon rates and lower origination expenses. We implemented a series of increases in our coupon rate beginning in September 2005 and continuing into our third quarter, and as a result, our WAC increased 79 basis points, from 7.48% to 8.27%. These rate changes, which were partially offset by lower gains on derivatives, caused our net gain on sale — gross margin to increase 85 basis points. Our loan origination volumes decreased 29.1% from the second quarter.
To mitigate the risk of short-term changes in market interest rates, we use interest rate swaps and forward loan sale commitments. We recorded $5.1 million in net gains during the third quarter, compared to $60.8 million in the second quarter, related to our various derivative instruments. See note 8 to the condensed consolidated financial statements.
During the preceding quarter, we recorded a $28.7 million gain on the sale of available-for-sale residual interests. This gain accelerated cash flows from residual interests, and resulted in realization of previously recorded unrealized gains included in other comprehensive income. We had no similar transaction in the current quarter.
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The following table summarizes the key drivers of loan servicing revenues:
(dollars in 000s) | ||||||||
Three months ended | January 31, 2006 | October 31, 2005 | ||||||
Average servicing portfolio: | ||||||||
With related MSRs | $ | 59,344,676 | $ | 55,150,897 | ||||
Without related MSRs | 21,046,638 | 22,065,265 | ||||||
$ | 80,391,314 | $ | 77,216,162 | |||||
Ending servicing portfolio: | ||||||||
With related MSRs | $ | 60,787,507 | $ | 57,760,816 | ||||
Without related MSRs | 15,994,170 | 24,614,920 | ||||||
$ | 76,781,677 | $ | 82,375,736 | |||||
Number of loans serviced | 466,026 | 500,935 | ||||||
Average delinquency rate | 5.58 | % | 4.37 | % | ||||
Weighted average FICO score | 621 | 622 | ||||||
Weighted average interest rate (WAC) of portfolio | 7.63 | % | 7.47 | % | ||||
Value of MSRs | $ | 262,369 | $ | 245,928 |
Loan servicing revenues increased $5.7 million, or 5.7%, compared to the second quarter. The increase reflects a higher average loan servicing portfolio, which increased $3.2 billion, or 4.1%. The annualized rate earned on our entire servicing portfolio was 34 basis points for the current quarter, which was flat compared to the second quarter rate.
Total expenses decreased $10.9 million compared to the second quarter. Cost of services increased $15.3 million as a result of a higher average servicing portfolio during the current quarter. Cost of other revenues decreased $18.9 million, primarily due to a $13.5 million decrease in compensation and benefits as a result of 10.8% decrease in sales associates and lower origination-based incentives. Other expenses decreased $4.1 million for the current quarter, primarily due to cost savings initiatives, partially offset by $2.2 million in additional interest expense.
Selling, general and administrative expenses declined $7.2 million, or 14.8%, due to cost savings initiatives and lower marketing expenses.
Pretax income increased $21.2 million, or 45.9%, for the three months ended January 31, 2006 compared to the preceding quarter.
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Mortgage Services — Operating Statistics
(dollars in 000s) | ||||||||
Restated | ||||||||
Nine months ended | January 31, 2006 | January 31, 2005 | ||||||
Volume of loans originated: | ||||||||
Wholesale (non-prime) | $ | 28,557,235 | $ | 18,887,536 | ||||
Retail:Non-prime | 2,730,272 | 2,197,898 | ||||||
Prime | 1,173,417 | 637,801 | ||||||
$ | 32,460,924 | $ | 21,723,235 | |||||
Loan characteristics: | ||||||||
Weighted average FICO score(1) | 625 | 611 | ||||||
Weighted average interest rate for borrowers(1) | 7.71 | % | 7.32 | % | ||||
Weighted average loan-to-value(1) | 80.6 | % | 78.6 | % | ||||
Origination margin (% of origination volume):(2) | ||||||||
Loan sale premium | 1.39 | % | 2.83 | % | ||||
Residual cash flows from beneficial interest in Trusts | 0.54 | % | 0.66 | % | ||||
Gain (loss) on derivative instruments | 0.28 | % | 0.13 | % | ||||
Loan sale repurchase reserves | (0.15 | %) | (0.15 | %) | ||||
Retained mortgage servicing rights | 0.60 | % | 0.44 | % | ||||
2.66 | % | 3.91 | % | |||||
Cost of acquisition | (0.39 | %) | (0.56 | %) | ||||
Direct origination expenses | (0.60 | %) | (0.71 | %) | ||||
Net gain on sale — gross margin(3) | 1.67 | % | 2.64 | % | ||||
Other revenues | (0.01 | %) | 0.04 | % | ||||
Other cost of origination | (1.32 | %) | (1.57 | %) | ||||
Net margin | 0.34 | % | 1.11 | % | ||||
Total cost of origination | 1.92 | % | 2.28 | % | ||||
Total cost of origination and acquisition | 2.31 | % | 2.84 | % | ||||
Loan delivery: | ||||||||
Loan sales | $ | 32,265,319 | $ | 21,653,373 | ||||
Execution price(4) | 1.68 | % | 3.21 | % |
(1) | Represents non-prime production. | |
(2) | See “Reconciliation of Non-GAAP Financial Information” on page 44. | |
(3) | Defined as gain on sale of mortgage loans (including gain or loss on derivatives, mortgage servicing rights and net of direct origination and acquisition expenses) divided by origination volume. | |
(4) | Defined as total premium received divided by total balance of loans delivered to third-party investors or securitization vehicles (excluding mortgage servicing rights and the effect of loan origination expenses). |
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Mortgage Services — Operating Results
(in 000s) | ||||||||
Restated | ||||||||
Nine months ended | January 31, 2006 | January 31, 2005 | ||||||
Components of gains on sales: | ||||||||
Gain on mortgage loans | $ | 450,199 | $ | 544,428 | ||||
Gain (loss) on derivatives | 91,896 | 28,826 | ||||||
Gain on sales of residual interests | 28,675 | — | ||||||
Impairment of residual interests | (29,175 | ) | (7,162 | ) | ||||
541,595 | 566,092 | |||||||
Interest income: | ||||||||
Accretion — residual interests | 93,190 | 96,242 | ||||||
Other interest income | 10,837 | 7,948 | ||||||
104,027 | 104,190 | |||||||
Loan servicing revenue | 296,720 | 193,690 | ||||||
Other | 740 | 1,205 | ||||||
Total revenues | 943,082 | 865,177 | ||||||
Cost of services | 215,279 | 159,558 | ||||||
Cost of other revenues: | ||||||||
Compensation and benefits | 235,081 | 165,220 | ||||||
Occupancy | 32,329 | 26,468 | ||||||
Other | 76,297 | 58,040 | ||||||
343,707 | 249,728 | |||||||
Selling, general and administrative | 135,936 | 122,911 | ||||||
Total expenses | 694,922 | 532,197 | ||||||
Pretax income | $ | 248,160 | $ | 332,980 | ||||
Nine months ended January 31, 2006 compared to January 31, 2005
Mortgage Services’ revenues increased $77.9 million, or 9.0%, for the nine months ended January 31, 2006 compared to the prior year. Revenues increased as a result of higher loan servicing revenues, increased gains on derivatives and a gain on sale of residual interests, partially offset by lower margins on mortgage loans sold and impairments of residual interests.
The following table summarizes the key drivers of gains on sales of mortgage loans:
(dollars in 000s) | ||||||||
Nine months ended January 31, | 2006 | 2005 | ||||||
Application process: | ||||||||
Total number of applications | 290,476 | 232,001 | ||||||
Number of sales associates(1) | 3,486 | 3,523 | ||||||
Closing ratio(2) | 61.8 | % | 58.9 | % | ||||
Originations: | ||||||||
Total number of originations | 179,439 | 136,615 | ||||||
Weighted average interest rate for borrowers (WAC) | 7.71 | % | 7.32 | % | ||||
Average loan size | $ | 181 | $ | 159 | ||||
Total originations | $ | 32,460,924 | $ | 21,723,235 | ||||
Direct origination and acquisition expenses, net | $ | 321,177 | $ | 275,217 | ||||
Revenue (loan value): | ||||||||
Net gain on sale — gross margin(3) | 1.67 | % | 2.64 | % |
(1) | Includes all direct sales and back office sales support associates. | |
(2) | Percentage of loans funded divided by total applications in the period. | |
(3) | Defined as gain on sale of mortgage loans (including gain or loss on derivatives, mortgage servicing rights and net of direct origination and acquisition expenses) divided by origination volume. |
Gains on sales of mortgage loans decreased $94.2 million, primarily as a result of rapidly rising two-year swap rates and moderating demand by loan buyers, partially offset by increased origination volume. Market interest rates, based on the two-year swap, increased from an average of 3.10% last year to 4.45% in the current year. However, our WAC increased only 39 basis points, up to 7.71% from 7.32% in the prior year. Because our WAC was not more aligned with market rates, increased
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funding costs and poor pricing in the market, offset by derivative gains, our gross margin declined 97 basis points, to 1.67% from 2.64% last year. Origination volumes increased 49.4% over the prior year, due to increased productivity of our account executives and support staff, new product introductions, increased applications and a higher closing ratio.
Changes in our MSR assumptions, an increase in the average loan size and an increase in origination volume resulted in an increase of $101.7 million related to the retained MSR component of gains on sales of mortgage loans.
As a result of rising interest rates and an increase in the notional amounts of interest rate swaps in place as a result of increased origination volumes during the current year, we recorded a net $91.9 million in gains, compared to $28.8 million in the prior year, related to our various derivative instruments. See note 8 to the condensed consolidated financial statements.
We recorded a $0.6 million net favorable mark-to-market adjustment for our trading residuals during the current period, and a gain of $28.7 million on the sale of residual interests. During the prior year, we recorded $5.4 million in net favorable mark-to-market adjustments for our trading residuals.
During the nine months ended January 31, 2006, our available-for-sale residual interests performed better than expected in our internal valuation models, with lower credit losses than originally modeled, partially offset by higher interest rates. We recorded favorable pretax mark-to-market adjustments, which increased the fair value of our residual interests $47.8 million during the period. These adjustments were recorded, net of write-downs of $8.9 million and deferred taxes of $14.9 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests. Offsetting this increase were impairments of available-for-sale residual interests totaling $29.2 million, which were recorded in gains on sales of mortgage assets. Impairments increased $22.0 million over the prior year due to interest rates increasing greater than originally modeled and a decline in the value of older residuals based on loan performance.
During the current year, Gulf Coast hurricanes caused severe damage to property, including property securing mortgage loans underlying our beneficial and residual interests. As of January 31, 2006, we have exposure to losses related to approximately $359 million of loans in the affected areas, including $338 million related to loans underlying securitizations in which we hold a residual interest and $21 million related to loans that are in the Trusts or have been repurchased from the Trusts. At January 31, 2006, total 31+ days delinquencies in the affected areas were approximately $106 million, compared to approximately $50 million that were 31+ days delinquent prior to the hurricanes. We recorded a specific provision for estimated losses arising from hurricane damage totaling $6.0 million during our second quarter, based on an analysis of delinquent loans within the federally declared disaster areas. Of the total provision, $3.1 million was recorded as a reserve for losses on loans that we have or may be required to repurchase pursuant to existing standard representations and warranties, and $2.9 million was recorded as an impairment of our residual interests. There were no significant changes to the reserves during the third quarter. In addition to the residual impairments recorded this quarter, future write-downs of residual interests may be incurred and recorded in other comprehensive income. We are continuing to analyze our exposure to potential losses and the amount of losses ultimately realized may differ from amounts previously recorded.
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The following table summarizes the key drivers of loan servicing revenues:
(dollars in 000s) | ||||||||
Nine months ended January 31, | 2006 | 2005 | ||||||
Average servicing portfolio: | ||||||||
With related MSRs | $ | 54,784,155 | $ | 39,593,946 | ||||
Without related MSRs | 21,210,097 | 12,586,192 | ||||||
$ | 75,994,252 | $ | 52,180,138 | |||||
Ending servicing portfolio: | ||||||||
With related MSRs | $ | 60,787,507 | $ | 43,642,212 | ||||
Without related MSRs | 15,994,170 | 15,342,627 | ||||||
$ | 76,781,677 | $ | 58,984,839 | |||||
Number of loans serviced | 466,026 | 387,619 | ||||||
Average delinquency rate | 4.76 | % | 5.03 | % | ||||
Weighted average FICO score | 621 | 616 | ||||||
Weighted average interest rate (WAC) of portfolio | 7.51 | % | 7.50 | % | ||||
Value of MSRs | $ | 262,369 | $ | 147,511 |
Loan servicing revenues increased $103.0 million, or 53.2%, compared to the prior year. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the nine months ended January 31, 2006 increased $23.8 billion, or 45.6%, to $76.0 billion. The annualized rate earned on our entire servicing portfolio was 34 basis points for the current period, compared to 36 basis points in the prior year.
Total expenses for the nine months ended January 31, 2006, increased $162.7 million, or 30.6%, over the prior year. Cost of services increased $55.7 million as a result of a higher average servicing portfolio during the current period and increased amortization of MSRs. Cost of other revenues increased $94.0 million, primarily due to $69.9 million in increased compensation and benefits as a result of an increase in the average number of sales associates during the period and origination-based incentives. Occupancy expenses increased $5.9 million, or 22.1%, primarily as a result of an increase in branch offices and related equipment and utilities costs. Other expenses increased $18.3 million primarily as a result of $13.3 million in additional interest expense related to loans held on our balance sheet, coupled with increases in depreciation and supplies.
Selling, general and administrative expenses increased $13.0 million primarily due to $16.0 million in additional retail marketing costs.
Pretax income decreased $84.8 million to $248.2 million for the nine months ended January 31, 2006.
Fiscal 2006 outlook
For the fourth quarter of fiscal year 2006, we believe we can achieve funding volumes of approximately $8 billion to $9 billion resulting in full year origination growth of approximately 30%. As a result of higher WACs on funded mortgage loans, a stabilizing external rate environment and further cost-saving measures, we believe we will see origination margins of 90 to 100 basis points in the fourth quarter, resulting in an origination margin of 45 to 55 basis points for the full fiscal year. During the fourth quarter, we expect to take actions to reduce staffing levels and close a number of branches, which is estimated to result in a pretax charge of $10 million to $12 million. Excluding the charge associated with these actions, we believe that our fourth quarter cost of origination will approximate 175 basis points.
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BUSINESS SERVICES
This segment offers middle-market companies accounting, tax and consulting services, wealth management, retirement resources, payroll and benefits services, corporate finance and financial process outsourcing.
Business Services — Operating Statistics
Three months ended January 31, | Nine months ended January 31, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Accounting, tax and consulting: | ||||||||||||||||
Chargeable hours | 1,107,398 | 641,009 | 2,467,355 | 1,852,346 | ||||||||||||
Chargeable hours per person | 314 | 332 | 895 | 935 | ||||||||||||
Net billed rate per hour | $ | 145 | $ | 134 | $ | 141 | $ | 129 | ||||||||
Average margin per person | $ | 25,154 | $ | 25,194 | $ | 65,567 | $ | 64,621 |
Business Services — Operating Results
(in 000s) | ||||||||||||||||
Three months ended January 31, | Nine months ended January 31, | |||||||||||||||
Restated | Restated | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Service revenues: | ||||||||||||||||
Accounting, tax and consulting | $ | 187,154 | $ | 91,588 | $ | 392,772 | $ | 259,519 | ||||||||
Capital markets | 13,567 | 17,631 | 44,394 | 48,309 | ||||||||||||
Payroll, benefits and retirement services | 8,796 | 5,885 | 25,690 | 14,384 | ||||||||||||
Other services | 16,898 | 8,805 | 37,893 | 22,911 | ||||||||||||
226,415 | 123,909 | 500,749 | 345,123 | |||||||||||||
Other | 9,425 | 8,963 | 28,742 | 25,898 | ||||||||||||
Total revenues | 235,840 | 132,872 | 529,491 | 371,021 | ||||||||||||
Cost of services: | ||||||||||||||||
Compensation and benefits | 130,490 | 68,695 | 297,031 | 206,684 | ||||||||||||
Occupancy | 18,339 | 6,627 | 37,514 | 17,031 | ||||||||||||
Other | 20,124 | 8,129 | 43,421 | 31,151 | ||||||||||||
168,953 | 83,451 | 377,966 | 254,866 | |||||||||||||
Selling, general and administrative | 67,922 | 43,505 | 161,468 | 125,176 | ||||||||||||
Total expenses | 236,875 | 126,956 | 539,434 | 380,042 | ||||||||||||
Pretax income (loss) | $ | (1,035 | ) | $ | 5,916 | $ | (9,943 | ) | $ | (9,021 | ) | |||||
Three months ended January 31, 2006 compared to January 31, 2005
Business Services’ revenues for the three months ended January 31, 2006 increased $103.0 million, or 77.5%, from the prior year. This increase was primarily due to the acquisition of American Express Tax and Business Services, Inc., which increased accounting, tax and consulting revenues $95.4 million.
Capital markets revenues declined $4.1 million due to a 34.2% decline in the number of business valuation projects. Payroll, benefits and retirement services revenues increased $2.9 million primarily due to acquisitions completed during the third and fourth quarters of fiscal year 2005. Other service revenues increased $8.1 million as a result of acquisitions completed in the fourth quarter of fiscal year 2005 in our financial process outsourcing business and growth in wealth management services.
Total expenses increased $109.9 million, or 86.6%, for the three months ended January 31, 2006 compared to the prior year. Cost of services increased $85.5 million, primarily due to a $61.8 million increase in compensation and benefits. Compensation and benefits increased $57.9 million due to the American Express Tax and Business Services, Inc. acquisition. Baseline increases in the number of personnel and the average wage per employee, driven by marketplace competition for professional staff, also contributed to the increase. Occupancy expenses increased $11.7 million due primarily to acquisitions. Other cost of services increased $12.0 million primarily due to the American Express Tax and Business Services, Inc. acquisition.
Selling, general and administrative expenses increased $24.4 million primarily due to acquisitions and additional costs associated with our business development initiatives.
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The pretax loss for the three months ended January 31, 2006 of $1.0 million, which includes losses of $6.0 million from American Express Tax and Business Services, Inc., compared to pretax income of $5.9 million in the prior year.
Due to the seasonal nature of this segment’s business, operating results for the three months ended January 31, 2006 are not comparable to the three months ended October 31, 2005 and are not indicative of the expected results for the entire fiscal year.
Nine months ended January 31, 2006 compared to January 31, 2005
Business Services’ revenues for the nine months ended January 31, 2006 increased $158.5 million, or 42.7%, from the prior year. This increase was primarily due to a $133.3 million increase in accounting, tax and consulting revenues resulting primarily from the acquisition of American Express Tax and Business Services, Inc., which increased revenues $115.9 million. We also benefited from a 6.9% increase in the net billed rate per hour, excluding the impact of the acquisition.
Capital markets revenues declined $3.9 million due to a 19.6% decline in the number of business valuation projects. Payroll, benefits and retirement services revenues increased $11.3 million, or 78.6%, primarily due to acquisitions completed during the third and fourth quarters of fiscal year 2005. Other service revenues increased $15.0 million as a result of acquisitions completed in the fourth quarter of fiscal year 2005 in our financial process outsourcing business and growth in wealth management services.
Total expenses increased $159.4 million, or 41.9%, for the nine months ended January 31, 2006 compared to the prior year. Cost of services increased $123.1 million, primarily due to a $90.3 million increase in compensation and benefits. Compensation and benefits increased $72.0 million due to the American Express Tax and Business Services, Inc. acquisition. Baseline increases in the number of personnel and the average wage per employee, driven by marketplace competition for professional staff and other acquisitions completed in the third and fourth quarters of fiscal year 2005, also contributed to this increase. Occupancy expenses increased $20.5 million due primarily to acquisitions. Other cost of services increased $12.3 million primarily due to the American Express Tax and Business Services, Inc. acquisition.
Selling, general and administrative expenses increased $36.3 million primarily due to acquisitions and additional costs associated with our business development initiatives.
The pretax loss for the nine months ended January 31, 2006 was $9.9 million, which includes losses of $9.3 million from American Express Tax and Business Services, Inc., compared to $9.0 million in the prior year.
Fiscal 2006 outlook
Our fiscal year 2006 outlook for our Business Services segment is consistent with the discussion in our April 30, 2005 Form 10-K/A, except for the previously announced acquisition of American Express Tax and Business Services, Inc. effective October 1, 2005. We expect organic growth for this segment’s pretax income of approximately 30%, and expect the acquisition of American Express Tax and Business Services, Inc. will be accretive by two cents per diluted share for fiscal year 2006, after expected integration costs. We expect Business Services’ pretax income for fiscal year 2006 to increase nearly 75% over the prior year.
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INVESTMENT SERVICES
This segment is primarily engaged in offering advice-based brokerage services and investment planning. Our integration of investment advice and new service offerings are allowing us to shift our emphasis from a transaction-based client relationship to a more advice-based focus.
Investment Services — Operating Statistics
Three months ended | January 31, 2006 | January 31, 2005 | October 31, 2005 | |||||||||
Customer trades(1) | 255,879 | 245,612 | 233,262 | |||||||||
Customer daily average trades | 4,127 | 3,899 | 3,589 | |||||||||
Average revenue per trade(2) | $ | 113.83 | $ | 120.62 | $ | 123.16 | ||||||
Customer accounts:(3) | ||||||||||||
Traditional brokerage | 426,699 | 431,902 | 428,543 | |||||||||
Express IRAs | 381,859 | 295,676 | 378,200 | |||||||||
808,558 | 727,578 | 806,743 | ||||||||||
Ending balance of assets under administration (billions) | $ | 31.4 | $ | 28.4 | $ | 29.8 | ||||||
Average assets per traditional brokerage account | $ | 72,914 | $ | 65,339 | $ | 68,837 | ||||||
Average margin balances (millions) | $ | 529 | $ | 596 | $ | 560 | ||||||
Average customer payable balances (millions) | $ | 769 | $ | 989 | $ | 794 | ||||||
Number of advisors | 956 | 1,013 | 995 | |||||||||
Included in the numbers above are the following relating to fee-based accounts: | ||||||||||||
Customer household accounts | 8,806 | 7,263 | 8,547 | |||||||||
Average revenue per account | $ | 2,551 | $ | 2,149 | $ | 2,164 | ||||||
Ending balance of assets under administration (millions) | $ | 2,420 | $ | 1,911 | $ | 2,217 | ||||||
Average assets per active account | $ | 270,217 | $ | 248,400 | $ | 259,355 |
(1) | Includes only trades on which revenues are earned (“revenue trades”). Revenues are earned on both transactional and annuitized trades. | |
(2) | Calculated as total trade revenues divided by revenue trades. | |
(3) | Includes only accounts with a positive balance. |
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Investment Services — Operating Results
(in 000s) | ||||||||||||
Restated | ||||||||||||
Three months ended | January 31, 2006 | January 31, 2005 | October 31, 2005 | |||||||||
Service revenue: | ||||||||||||
Transactional revenue | $ | 23,078 | $ | 24,654 | $ | 23,332 | ||||||
Annuitized revenue | 25,300 | 18,382 | 23,062 | |||||||||
Production revenue | 48,378 | 43,036 | 46,394 | |||||||||
Other service revenue | 8,169 | 7,000 | 8,064 | |||||||||
56,547 | 50,036 | 54,458 | ||||||||||
Margin interest revenue | 15,947 | 11,975 | 14,826 | |||||||||
Less: interest expense | (1,789 | ) | (1,090 | ) | (1,363 | ) | ||||||
Net interest revenue | 14,158 | 10,885 | 13,463 | |||||||||
Other | 682 | 93 | 734 | |||||||||
Total revenues(1) | 71,387 | 61,014 | 68,655 | |||||||||
Cost of services: | ||||||||||||
Compensation and benefits | 35,901 | 28,986 | 32,676 | |||||||||
Occupancy | 5,283 | 5,948 | 5,187 | |||||||||
Other | 5,626 | 5,530 | 5,541 | |||||||||
46,810 | 40,464 | 43,404 | ||||||||||
Selling, general and administrative | 32,245 | 40,325 | 33,157 | |||||||||
Total expenses | 79,055 | 80,789 | 76,561 | |||||||||
Pretax loss | $ | (7,668 | ) | $ | (19,775 | ) | $ | (7,906 | ) | |||
(1) | Total revenues, less interest expense. |
Three months ended January 31, 2006 compared to January 31, 2005
Investment Services’ revenues, net of interest expense, for the three months ended January 31, 2006 increased $10.4 million, or 17.0%.
Production revenue increased $5.3 million, or 12.4%, over the prior year. Transactional revenue, which is based on sales of individual securities, decreased $1.6 million, or 6.4%, from the prior year due primarily to a 5.5% decrease in average revenue per transactional trade and a 0.4% decrease in transactional trading volume. Annuitized revenue, which is based on sales of various fee-based products, increased $6.9 million, or 37.6%, due to increased sales of annuities and insurance, wealth management accounts, mutual funds, and unit investment trusts (UITs). The shift in revenues from transactional to annuitized demonstrates our continued move toward an advice-based focus.
Annualized productivity averaged approximately $201,000 per advisor during the current quarter compared to $172,000 in the prior year. Increased productivity was due to higher production levels across all recruiting classes. Minimum production standards put into place during the fourth quarter of fiscal year 2005 resulted in 122 advisors increasing their production to date. These standards also resulted in 141 low-producing advisors leaving the company to date. We expect average advisor productivity to continue increasing throughout the remainder of the fiscal year.
Margin interest revenue increased $4.0 million, or 33.2%, from the prior year, as a result of higher interest rates earned, partially offset by a decline in average margin balances.
Total expenses decreased $1.7 million, or 2.1%. Cost of services increased $6.3 million, or 15.7%, primarily as a result of $6.9 million of additional compensation and benefits expenses resulting from higher production revenues.
Selling, general and administrative expenses decreased $8.1 million, or 20.0%, primarily due to a $3.9 million decline in legal expenses, due in part to a favorable arbitration outcome. Current quarter results also improved due to reduced back-office headcount relating to cost containment efforts and gains on the disposition of certain assets during the quarter. These decreases were partially offset by increased bonus accruals associated with the segment’s improved performance.
The pretax loss for Investment Services for the three months ended January 31, 2006 was $7.7 million compared to the prior year loss of $19.8 million.
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Three months ended January 31, 2006 compared to October 31, 2005
Investment Services’ revenues, net of interest expense, for the three months ended January 31, 2006 increased $2.7 million, or 4.0% compared to the preceding quarter.
Production revenue increased $2.0 million, or 4.3%, over the preceding quarter, primarily due to increased sales of wealth management accounts, mutual funds, annuities and insurance.
Total expenses increased $2.5 million, or 3.3%. Compensation and benefits increased $3.2 million, primarily resulting from higher production revenues. This increase was partially offset by a $2.5 million decrease in legal expenses, due in part to a favorable arbitration outcome.
The pretax loss for the Investment Services segment was $7.7 million, compared to a loss of $7.9 million in the second quarter of fiscal year 2006.
Investment Services — Operating Statistics
Nine months ended | January 31, 2006 | January 31, 2005 | ||||||
Customer trades(1) | 715,519 | 644,469 | ||||||
Customer daily average trades | 3,766 | 3,410 | ||||||
Average revenue per trade(2) | $ | 120.94 | $ | 121.68 | ||||
Customer accounts:(3) | ||||||||
Traditional brokerage | 426,699 | 431,902 | ||||||
Express IRAs | 381,859 | 295,676 | ||||||
808,558 | 727,578 | |||||||
Ending balance of assets under administration (billions) | $ | 31.4 | $ | 28.4 | ||||
Average assets per traditional brokerage account | $ | 72,914 | $ | 65,339 | ||||
Average margin balances (millions) | $ | 554 | $ | 595 | ||||
Average customer payable balances (millions) | $ | 801 | $ | 988 | ||||
Number of advisors | 956 | 1,013 | ||||||
Included in the numbers above are the following relating to fee-based accounts: | ||||||||
Customer household accounts | 8,806 | 7,263 | ||||||
Average revenue per account | $ | 2,319 | $ | 2,039 | ||||
Ending balance of assets under administration (millions) | $ | 2,420 | $ | 1,911 | ||||
Average assets per active account | $ | 270,217 | $ | 248,400 |
(1) | Includes only trades on which revenues are earned (“revenue trades”). Revenues are earned on both transactional and annuitized trades. | |
(2) | Calculated as total trade revenues divided by revenue trades. | |
(3) | Includes only accounts with a positive balance. |
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Investment Services — Operating Results
(in 000s) | ||||||||
Restated | ||||||||
Nine months ended | January 31, 2006 | January 31, 2005 | ||||||
Service revenue: | ||||||||
Transactional revenue | $ | 69,245 | $ | 64,594 | ||||
Annuitized revenue | 70,633 | 54,114 | ||||||
Production revenue | 139,878 | 118,708 | ||||||
Other service revenue | 24,440 | 19,789 | ||||||
164,318 | 138,497 | |||||||
Margin interest revenue | 44,866 | 30,773 | ||||||
Less: interest expense | (4,406 | ) | (1,930 | ) | ||||
Net interest revenue | 40,460 | 28,843 | ||||||
Other | 1,993 | 176 | ||||||
Total revenues(1) | 206,771 | 167,516 | ||||||
Cost of services: | ||||||||
Compensation and benefits | 99,112 | 84,908 | ||||||
Occupancy | 15,635 | 16,510 | ||||||
Other | 16,102 | 14,885 | ||||||
130,849 | 116,303 | |||||||
Selling, general and administrative | 99,048 | 112,095 | ||||||
Total expenses | 229,897 | 228,398 | ||||||
Pretax loss | $ | (23,126 | ) | $ | (60,882 | ) | ||
(1) | Total revenues, less interest expense. |
Nine months ended January 31, 2006 compared to January 31, 2005
Investment Services’ revenues, net of interest expense, for the nine months ended January 31, 2006 increased $39.3 million, or 23.4%, over the prior year.
Production revenue increased $21.2 million, or 17.8%, over the prior year. Transactional revenue increased $4.7 million, or 7.2%, from the prior year due primarily to a 6.6% increase in transactional trading volume and a 1.8% increase in average revenue per transactional trade. Annuitized revenue increased $16.5 million, or 30.5%, due to increased sales of annuities, insurance, mutual funds, wealth management accounts and UITs.
Annualized productivity averaged approximately $187,000 per advisor during the current year compared to $158,000 in the prior year. Increased productivity was due to higher production levels across all recruiting classes. Minimum production standards put into place during the fourth quarter of fiscal year 2005 resulted in 122 advisors increasing their production to date. These standards also resulted in 141 low-producing advisors leaving the company to date.
Other service revenue increased $4.7 million due to increased money market, account and underwriting fees.
Margin interest revenue increased $14.1 million, or 45.8%, from the prior year, as a result of higher interest rates earned, partially offset by lower average margin balances.
Total expenses increased $1.5 million, or 0.7%. Cost of services increased $14.5 million, or 12.5%, primarily as a result of $14.2 million of additional compensation and benefits. This increase is primarily due to higher production revenues, partially offset by cost containment measures implemented in the fourth quarter of fiscal year 2005.
Selling, general and administrative expenses decreased $13.0 million, or 11.6%, primarily due to a $5.6 million decline in legal expenses, due in part to a favorable arbitration outcome. We also experienced a $4.3 million decline in compensation and benefits from reduced back-office headcount relating to cost containment efforts and $3.2 million in additional gains on the disposition of certain assets during the year. These decreases were partially offset by increased bonuses associated with the segment’s improved performance.
The pretax loss for Investment Services through January 31, 2006 was $23.1 million compared to the prior year loss of $60.9 million.
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Fiscal 2006 outlook
Our fiscal year 2006 outlook for our Investment Services segment has improved slightly from the discussion in our April 30, 2005 Form 10-K/A. We now anticipate the loss for Investment Services for fiscal year 2006 will be approximately $30 million to $37 million less than the loss reported in fiscal year 2005, instead of the $25 million to $35 million improvement we previously discussed.
CORPORATE
This segment consists primarily of corporate support departments, which provide services to our operating segments. These support departments consist of marketing, information technology, facilities, human resources, executive, legal, finance, government relations and corporate communications. Support department costs are generally allocated to our operating segments. Our captive insurance and franchise financing subsidiaries are also included within this segment, as was our small business initiatives subsidiary in the first half of fiscal year 2005.
Corporate — Operating Results
(in 000s) | ||||||||||||||||
Three months ended January 31, | Nine months ended January 31, | |||||||||||||||
Restated | Restated | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Operating revenues | $ | 5,857 | $ | 3,425 | $ | 15,266 | $ | 10,290 | ||||||||
Eliminations | (3,113 | ) | (2,123 | ) | (8,731 | ) | (6,833 | ) | ||||||||
Total revenues | 2,744 | 1,302 | 6,535 | 3,457 | ||||||||||||
Corporate expenses: | ||||||||||||||||
Interest expense | 20,334 | 20,937 | 49,566 | 55,673 | ||||||||||||
Other | 12,559 | 12,317 | 44,396 | 35,422 | ||||||||||||
32,893 | 33,254 | 93,962 | 91,095 | |||||||||||||
Shared services: | ||||||||||||||||
Information technology | 30,068 | 29,023 | 85,615 | 81,435 | ||||||||||||
Marketing | 52,574 | 46,030 | 63,655 | 57,292 | ||||||||||||
Finance | 11,072 | 9,107 | 36,138 | 26,620 | ||||||||||||
Other | 38,610 | 31,584 | 82,944 | 78,179 | ||||||||||||
132,324 | 115,744 | 268,352 | 243,526 | |||||||||||||
Allocation of shared services | (131,952 | ) | (117,297 | ) | (268,370 | ) | (245,096 | ) | ||||||||
Other income, net | 3,511 | 18,398 | 12,430 | 20,574 | ||||||||||||
Pretax loss | $ | (27,010 | ) | $ | (12,001 | ) | $ | (74,979 | ) | $ | (65,494 | ) | ||||
Three months ended January 31, 2006 compared to January 31, 2005
Marketing department expenses increased $6.5 million, or 14.2%, due primarily to an increase in digital advertising efforts. Finance department expenses increased $2.0 million, primarily due to additional consulting expenses and increases in compensation expenses. Other support department expenses increased $7.0 million primarily due to increases in stock-based compensation expenses.
Other income declined $14.9 million primarily as a result of a $16.7 million legal recovery we received during the prior year quarter.
The pretax loss was $27.0 million, compared with last year’s third quarter loss of $12.0 million.
Due to the nature of this segment, the three months ended January 31, 2006 are not comparable to the three months ended October 31, 2005 and are not indicative of the expected results for the entire fiscal year.
Our effective tax rate for the quarter increased to 52.3% compared to 38.8% in the prior year. This increase is due to an additional $3.4 million in income tax expense in the current quarter related to the correction of errors in state income taxes for periods prior to May 1, 2003. See discussion of restatement in note 2A to the condensed consolidated financial statements.
Nine months ended January 31, 2006 compared to January 31, 2005
Corporate expenses increased $2.9 million primarily due an increase of $4.6 million in allocated costs from finance shared services and $1.5 million in additional consulting, accounting and auditing expenses related to the restatement of our previously issued financial statements. These increases were partially offset by a decline of $6.1 million in interest expense.
Our consolidated interest expense, both operating and non-operating, totaled $74.3 million for the nine months ended January 31, 2006, an increase of $9.3 million over the prior year. Of the $74.3 million in total interest, $37.0 million related to interest expense on previous acquisitions, with the
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remaining $37.3 million related to our operations recorded directly in our operating segments. Intercompany interest expense, which is also recorded directly in our operating segments, is eliminated within the Corporate segment. These eliminations resulted in the decline of $6.1 million in interest expense recorded in our Corporate segment for the current period.
Information technology department expenses increased $4.2 million primarily due to higher compensation and benefits. Marketing department expenses increased $6.4 million primarily due to an increase in digital advertising. Finance department expenses increased $9.5 million, primarily due to $5.1 million of additional consulting expenses and an increase of $4.5 million in compensation expenses. Other support department expenses increased $4.8 million primarily due to increases in stock-based compensation and legal department expenses, partially offset by a decrease in supply department expenses.
Other income decreased $8.1 million primarily as a result of a $16.7 million legal recovery received during the prior year, partially offset by a $3.4 million gain recognized on the sale of an investment in the current year.
The pretax loss was $75.0 million, compared with last year’s loss of $65.5 million.
Our effective tax rate for the nine months ended January 31, 2006 decreased to 36.8% compared to 38.7% in the prior year. This decrease is due to an additional $3.4 million in income tax expense in the current quarter related to the correction of errors in state income taxes for periods prior to May 1, 2003. See discussion of restatement in note 2A to the condensed consolidated financial statements.
FINANCIAL CONDITION
These comments should be read in conjunction with the condensed consolidated balance sheets and condensed consolidated statements of cash flows found on pages 1 and 3, respectively.
CAPITAL RESOURCES & LIQUIDITY BY SEGMENT
Our sources of capital include cash from operations, issuances of common stock and debt. We use capital primarily to fund working capital requirements, pay dividends, repurchase our shares and acquire businesses.
Cash From Operations.Cash used in operations totaled $1.7 billion and $1.6 billion for the nine months ended January 31, 2006 and 2005, respectively. The increase in cash used in operating activities is primarily due to increases in mortgage loans held for sale and MSRs during the current year and increased losses. These items were partially offset by a decline in income tax payments. Income tax payments totaled $224.8 million during the current year, a decrease of $181.8 million from the prior year.
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 $105.8 million and $119.9 million for the nine months ended January 31, 2006 and 2005, respectively.
Dividends.Dividends paid totaled $118.7 million and $106.4 million for the nine months ended January 31, 2006 and 2005, respectively. On June 8, 2005, our Board of Directors declared a two-for-one stock split of the Company’s Common Stock in the form of a 100% stock distribution, effective August 22, 2005, to shareholders of record as of the close of business on August 1, 2005. All share and per share amounts in this document have been adjusted to reflect the retroactive effect of the stock split.
Share Repurchases.On June 9, 2004, our Board of Directors approved an authorization to repurchase 15 million shares. During the nine months ended January 31, 2006, we repurchased 9.0 million shares pursuant to this authorization and a prior authorization at an aggregate price of $254.2 million or an average price of $28.18 per share. There are 10.5 million shares remaining under this authorization at January 31, 2006. We plan to continue to purchase shares on the open market in accordance with this authorization, subject to various factors including the price of the stock, the availability of excess cash, our ability to maintain liquidity and financial flexibility, securities law restrictions, targeted capital levels and other investment opportunities available.
Restricted Cash.We hold certain cash balances that are restricted as to use. Cash and cash equivalents — restricted totaled $430.7 million at January 31, 2006 compared to $516.9 million at April 30, 2005. Investment Services held $376.0 million of this total segregated in a special reserve account for the exclusive benefit of customers. Restricted cash held by Mortgage Services totaled $48.1 million and is held primarily for outstanding commitments to fund mortgage loans. Restricted
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cash of $6.6 million at January 31, 2006 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, 2006 follows. Generally, interest is not charged on intercompany activities between segments.
(in 000s) | ||||||||||||||||||||||||
Tax | Mortgage | Business | Investment | Consolidated | ||||||||||||||||||||
Services | Services | Services | Services | Corporate | H&R Block | |||||||||||||||||||
Cash provided by (used in): | ||||||||||||||||||||||||
Operations | $ | (1,047,425 | ) | $ | (349,287 | ) | $ | 5,279 | $ | 14,691 | $ | (312,805 | ) | $ | (1,689,547 | ) | ||||||||
Investing | (49,221 | ) | 72,246 | (220,392 | ) | 9,143 | (66,048 | ) | (254,272 | ) | ||||||||||||||
Financing | (2,051 | ) | — | (21,013 | ) | 5,642 | 2,321,208 | 2,303,786 | ||||||||||||||||
Net intercompany | 1,315,359 | 281,885 | 250,446 | (10,544 | ) | (1,837,146 | ) | — |
Net intercompany activities are excluded from investing and financing activities within the segment cash flows. We believe that by excluding intercompany activities, the cash flows by segment more clearly depicts the cash generated and used by each segment. Had intercompany activities been included, those segments in a net lending situation would have been included in investing activities, and those in a net borrowing situation would have been included in financing activities.
Tax Services.Tax Services has historically been our largest provider of annual operating cash flows. The seasonal nature of Tax Services generally results in a large positive operating cash flow in the fourth quarter. Tax Services used $1.0 billion in its current nine-month operations to cover off-season costs and working capital requirements. Cash used for seasonal working capital requirements was partially offset by a signing bonus received from HSBC during the second quarter in connection with the execution of a RAL distribution agreement. The signing bonus was recorded as deferred revenue at January 31, 2006. This segment also used $49.2 million in investing activities, primarily related to capital expenditures and acquisitions.
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 used $349.3 million in cash from operating activities primarily due to a $192.0 million increase in mortgage loans held for sale at January 31, 2006. Additionally, net additions to MSRs totaled $95.8 million and servicing advances increased $61.5 million. Cash flows from investing activities consist of $74.9 million in cash receipts on residual interests and $30.5 million in cash received for the sale of residual interests, partially offset by $32.9 million in capital expenditures.
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, 2006 and April 30, 2005, the balance outstanding under this facility was $0.4 million and $4.4 million, respectively.
To fund our non-prime originations, we utilize nine off-balance sheet warehouse Trusts. The facilities used by the Trusts had a total committed capacity of $15.0 billion as of January 31, 2006. Amounts drawn on the facilities by the Trusts totaled $11.2 billion at January 31, 2006. See additional discussion below in “Off-Balance Sheet Financing Arrangements.”
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 provided $5.3 million in operating cash flows during the first nine months of the year. Business Services used $220.4 million in investing activities primarily related to the American Express Tax and Business Services, Inc. acquisition and, to a lesser extent, capital expenditures.
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, 2006, HRBFA’s net capital of $117.6 million, which was 20.1% of aggregate debit items, exceeded its minimum required net capital of $11.7 million by $105.9 million.
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In the first nine months of fiscal year 2006, Investment Services provided $14.7 million in cash from its operating activities primarily due to working capital changes, including the timing of cash deposits that are restricted for the benefit of customers.
Liquidity needs relating to client trading and margin-borrowing activities are met primarily through cash balances in client brokerage accounts and working capital. We believe these sources of funds will continue to be the primary sources of liquidity for Investment Services. Stock loans have historically been used as a secondary source of funding and could be used in the future, if warranted.
Pledged securities at January 31, 2006 totaled $51.9 million, an excess of $11.7 million over the margin requirement. Pledged securities at the end of fiscal year 2005 totaled $44.6 million, an excess of $7.9 million over the margin requirement.
We believe the funding sources for Investment Services are stable. Liquidity risk within this segment is primarily limited to maintaining sufficient capital levels to obtain securities lending liquidity to support margin borrowing by customers.
OFF-BALANCE SHEET FINANCING ARRANGEMENTS
Substantially all non-prime mortgage loans we originate are sold daily to the Trusts. The Trusts purchase the loans from us utilizing nine warehouse facilities that were arranged by us, bear interest at one-month LIBOR plus 45 to 400 basis points and expire on various dates during the year. During the third quarter, the warehouse facilities were increased from $13.5 billion to $15.0 billion. An additional uncommitted facility of $1.5 billion brings total capacity to $16.5 billion.
There have been no other material changes in our off-balance sheet financing arrangements from those reported at April 30, 2005 in our Annual Report on Form 10-K/A.
COMMERCIAL PAPER ISSUANCE AND SHORT-TERM BORROWINGS
We maintain two unsecured CLOCs for working capital, support of our commercial paper program and general corporate purposes. In August 2005, the first CLOC expired and was replaced with a new $1.0 billion CLOC, which expires in August 2010. Also in August 2005, the second CLOC was extended, and now expires in August 2010. These CLOCs were undrawn at January 31, 2006.
We obtained an additional $900.0 million line of credit for the period of January 3 to February 24, 2006 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. The balance outstanding on this facility at January 31, 2006 was $550.0 million.
There have been no other material changes in our commercial paper program from those reported at April 30, 2005 in our Annual Report on Form 10-K/A.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
As a result of our failure to file this Form 10-Q by the SEC’s prescribed due date, we will be unable to issue any debt securities under our shelf registration statement for a period of twelve calendar months after the month of our filing.
There have been no other material changes in our contractual obligations and commercial commitments from those reported at April 30, 2005 in our Annual Report on Form 10-K/A.
REGULATORY ENVIRONMENT
There have been no material changes in our regulatory environment from those reported at April 30, 2005 in our Annual Report on Form 10-K/A.
FORWARD-LOOKING INFORMATION
In this report, and from time to time throughout the year, we share our expectations for our future performance. These forward-looking statements are based upon current information, expectations, estimates and projections regarding the Company, the industries and markets in which we operate, and our assumptions and beliefs at that time. These statements speak only as of the date on which they are made, are not guarantees of future performance, and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results could materially differ from what is expressed, implied or forecast in these forward-looking statements. Words such as “believe,” “will,” “plan,” “expect,” “intend,” “estimate,” “approximate,” and similar expressions may identify such forward-looking statements.
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There have been no material changes in our risk factors from those reported at April 30, 2005 in our Annual Report on Form 10-K/A.
RECONCILIATION OF NON-GAAP FINANCIAL INFORMATION
We report our financial results in accordance with generally accepted accounting principles (GAAP). However, we believe certain non-GAAP performance measures and ratios used in managing the business may provide additional meaningful comparisons between current year results and prior periods, by excluding certain items that do not represent results from our basic operations. Reconciliations to GAAP financial measures are provided below. These non-GAAP financial measures should be viewed in addition to, not as an alternative for, our reported GAAP results.
Origination Margin
(dollars in 000s) | |||||||||||||||||||||
Three months ended | Nine months ended | ||||||||||||||||||||
Restated | Restated | ||||||||||||||||||||
January 31, | January 31, | October 31, | January 31, | January 31, | |||||||||||||||||
2006 | 2005 | 2005 | 2006 | 2005 | |||||||||||||||||
Total expenses | $ | 229,040 | $ | 193,389 | $ | 239,912 | $ | 694,922 | $ | 532,197 | |||||||||||
Add: Expenses netted against gain on sale revenues | 85,974 | 102,878 | 120,981 | 321,177 | 275,217 | ||||||||||||||||
Less: | |||||||||||||||||||||
Cost of services | 83,076 | 56,766 | 67,811 | 215,279 | 159,558 | ||||||||||||||||
Cost of acquisition | 24,305 | 50,084 | 50,591 | 127,201 | 122,194 | ||||||||||||||||
Allocated support departments | 6,549 | 6,244 | 6,793 | 19,173 | 18,391 | ||||||||||||||||
Other | 11,291 | 6,900 | 10,300 | 29,891 | 10,900 | ||||||||||||||||
$ | 189,793 | $ | 176,273 | $ | 225,398 | $ | 624,555 | $ | 496,371 | ||||||||||||
Divided by origination volume | $ | 8,952,487 | $ | 8,393,735 | $ | 12,620,808 | $ | 32,460,924 | $ | 21,723,235 | |||||||||||
Total cost of origination | 2.12 | % | 2.10 | % | 1.79 | % | 1.92 | % | 2.28 | % |
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in our market risks from those reported at April 30, 2005 in our Annual Report on Form 10-K/A.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
We have established disclosure controls and procedures (Disclosure Controls) to ensure that information required to be disclosed in the Company’s reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms. Disclosure Controls are also designed to ensure that such information is accumulated and communicated to management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure. Our Disclosure Controls were designed to provide reasonable assurance that the controls and procedures would meet their objectives. Our management, including the Chief Executive Officer and Chief Financial Officer, 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 error or mistake. 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 the end of the period covered by this Form 10-Q, 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 Chief Executive Officer and Chief Financial Officer, and included consideration of the material weakness initially disclosed in our Annual Report on Form 10-K/A for the year ended April 30, 2005. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our Disclosure Controls and procedures were not effective as of the end of the period covered by this Quarterly Report on Form 10-Q because of the material weakness described below.
As disclosed initially in our Annual Report on Form 10-K/A for the year ended April 30, 2005, management identified a material weakness in our accounting for income taxes. Specifically, the Company did not maintain sufficient resources in the corporate tax function to accurately identify, evaluate and report, in a timely manner, non-routine and complex transactions. In addition, the Company had not completed the requisite historical analysis and related reconciliations to ensure tax balances were appropriately stated prior to the completion of the Company’s April 30, 2005 internal control activities.
In February 2006, as a result of the ongoing controls and procedural work to remediate the material weakness in the Company’s internal controls over accounting for income taxes as of April 30, 2005, management discovered additional income tax errors which required the restatement of prior periods. In preparation for its 10-Q filing, management reviewed this disclosure and believes it accurately describes the nature of the internal control deficiencies that contributed to the material weakness as of April 30, 2005.
CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
In order to remediate the aforementioned material weakness, management completed the requisite historical analysis including creation of the necessary tax basis balance sheets and current and deferred reconciliations required and related internal control testing to ensure propriety of all tax related financial statement account balances as of the Form 10-K/A filing date. The Company believes it established appropriate controls and procedures and created appropriate tax account analysis and support subsequent to April 30, 2005.
Additionally, in our efforts to remediate the material weakness management has engaged a third-party firm to assist us in performing a comprehensive evaluation of the corporate tax function, including resource requirements. Since August 1, 2005, we have hired a Senior Vice President — Corporate Tax, an Income Tax Accounting Manager, a Corporate Tax Manager and two additional Tax Analysts. In addition to implementing management’s action plan addressing items from the comprehensive evaluation, we will continue to monitor the improvements in the controls over accounting for income taxes to ensure remediation of the material weakness.
Other than the changes outlined above, there were no changes that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information below should be read in conjunction with the information included in note 12 to our condensed consolidated financial statements.
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RAL LITIGATION
We reported in current reports on Form 8-K, previous quarterly reports on Form 10-Q, and in our annual report on Form 10-K/A for the year ended April 30, 2005, 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 Act; violations of the federal Fair Debt Collection Practices Act; and breach of fiduciary duty to our customers in connection with the RAL program.
The amounts claimed in the RAL Cases have been very substantial in some instances. We have successfully defended against numerous RAL Cases, although several of the RAL Cases are still pending. Of the RAL Cases that are no longer pending, some were dismissed on our motions for dismissal or summary judgment, and others were dismissed voluntarily by the plaintiffs after denial of class certification. Other cases have been settled, with one settlement resulting in a pretax expense of $43.5 million in fiscal year 2003 (the “Texas RAL Settlement”). On December 21, 2005, we entered into a settlement agreement, subject to final court approval, regarding four RAL Cases entitledDeadra D. Cummins, et al.v. H&R Block,Inc. et al.;Mitchell v. H&R Block, Inc. et al.;Green v. H&R Block, Inc. et al.; andBecker v. H&R Block, Inc.(the “CumminsSettlement Agreement”). Pursuant to the terms of theCumminsSettlement Agreement, we will contribute a total of up to $62.5 million in cash for purposes of making payments to the settlement class, paying all attorneys’ fees and costs to class counsel and covering service awards to the representative plaintiffs. In addition, we will pay costs for providing notice of the settlement to settlement class members. We recorded a reserve of $52.2 million related to this settlement in our third quarter.
We 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. Likewise, there can be no assurances regarding the impact of the RAL Cases on our financial statements. We have accrued our best estimate of the probable loss related to the RAL Cases. The following is updated information regarding the pending RAL Cases that are class actions or putative class actions in which developments occurred during or after the three months ended January 31, 2006:
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. In March 2004, the court either dismissed or decertified all of the plaintiffs’ claims other than part of one count alleging violations of the racketeering and conspiracy provisions of the Racketeer Influenced and Corrupt Organizations Act. On January 23, 2006, the court granted our motion for partial summary judgment applying a four-year RICO statute of limitations to the plaintiffs’ claims, reducing the class period to primarily the 1995 and 1996 tax seasons and reducing the class size to approximately 1.7 million members. This class action case is scheduled to go to trial on May 15, 2006. We intend to continue defending the case vigorously, but there are no assurances as to its outcome. We have, however, engaged in settlement discussions with counsel for the plaintiffs and, while no definitive agreement has been reached, plan to pursue those negotiations to either conclusion or take the matter to trial. During the quarter ended January 31, 2006, we increased our legal reserves related to this matter by $19.5 million in connection with these developments.
Deadra D. Cummins, et al. v. H&R Block, Inc., et al., Case No. 03-C-134 in the Circuit Court of Kanawha County, West Virginia, instituted on January 22, 2003. This case is stayed and will be resolved as part of theCumminsSettlement Agreement, subject to final approval.
Joyce Green, et al. v. H&R Block, Inc., Block Financial Corporation, et al., Case No. 97195023, in the Circuit Court for Baltimore City, Maryland, instituted on July 14, 1997. This case is stayed and will be resolved as part of theCumminsSettlement Agreement, subject to final approval.
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Levon and Geral Mitchell, et al. v. H&R Block,, Inc. and Ruth Wren,Case No. CV-95-2067, in the Circuit Court of Mobile County, Alabama, instituted on June 13, 1995. This case is stayed and will be resolved as part of theCumminsSettlement Agreement, subject to final approval.
Lynn Becker v. H&R Block, Inc.,Case No. CV-2004-03-1680 in the Court of Common Pleas, Summit County, Ohio, Instituted on April 15, 2004. This case is stayed and will be resolved as part of theCumminsSettlement Agreement, subject to final approval.
On February 15, 2006, the California attorney general filed a lawsuit in the Superior Court of California, City and County of San Francisco entitledThe People of California v. H&R Block, Inc., H&R Block Services, Inc., H&R Block Enterprises, Inc., H&R Block Tax Services, Inc., Block Financial Corporation, HRB Royalty, Inc. and Does 1 through 50. The complaint alleges, among other things, untrue, misleading or deceptive statements in marketing RALS and unfair competition with respect to debt collection activities. The complaint seeks equitable relief, civil penalties and restitution. We intend to defend the case vigorously, but there are no assurances as to its outcome.
PEACE OF MIND LITIGATION
Lorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Civil Action 2003L000004, in the Circuit Court of Madison County, Illinois, is a class action case filed on January 18, 2002, that was granted class certification on August 27, 2003. Plaintiffs’ claims consist of five counts relating to the Peace of Mind (POM) program under which the applicable tax return preparation subsidiary assumes liability for additional tax assessments attributable to tax return preparation error. The plaintiffs allege that the sale of POM guarantees constitutes (i) statutory fraud by selling insurance without a license, (ii) an unfair trade practice, by omission and by “cramming” (i.e., charging customers for the guarantee even though they did not request it or want it), and (iii) a breach of fiduciary duty. In August 2003, the court certified the plaintiff classes consisting of all persons who from January 1, 1997 to final judgment (i) were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member; (ii) reside in certain class states and were charged a separate fee for POM by “H&R Block” or a defendant H&R Block class member not licensed to sell insurance; and (iii) had an unsolicited charge for POM posted to their bills by “H&R Block” or a defendant H&R Block class member. Persons who received the POM guarantee through an H&R Block Premium office and persons who reside in Alabama are excluded from the plaintiff class. The court also certified a defendant class consisting of any entity with names that include “H&R Block” or “HRB,” or are otherwise affiliated or associated with H&R Block Tax Services, Inc., and that sold or sells the POM product. The trial court subsequently denied the defendants’ motion to certify 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 POM guarantee. This case is being tried before the same judge that presided over the Texas RAL Settlement, involves the same plaintiffs’ attorneys that are involved in the Marshall litigation in Illinois, and contains similar allegations. No class has been certified in this case.
We believe the claims in the POM action are without merit, and we intend to defend them vigorously. The amounts claimed in the POM actions are substantial, however, and there can be no assurances as to the outcome of these pending actions individually or in the aggregate. Likewise, there can be no assurances regarding the impact of these actions on our consolidated financial statements.
OTHER CLAIMS AND LITIGATION
As reported previously, the NASD brought charges against HRBFA regarding the sale by HRBFA of Enron debentures in 2001. A hearing for this matter is scheduled for May 2, 2006. We intend to defend the NASD charges vigorously, although there can be no assurances regarding the outcome and resolution of the matter.
As part of an industry-wide review, the 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. Some of these clients are seeking or may attempt to seek recovery from
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RSM. While there can be no assurance regarding the outcome of these matters, we do not believe its resolution will have a material adverse effect on our operations or consolidated financial statements.
On March 15, 2006, the New York Attorney General filed a lawsuit in the Supreme Court of the State of New York, County of New York entitledThe People of New York v. H&R Block, Inc. and H&R Block Financial Services, Inc.The complaint alleges fraudulent business practices, deceptive acts and practices, common law fraud and breach of fiduciary duty with respect to the Express IRA product. The complaint seeks equitable relief, disgorgement of profits, damages and restitution, civil penalties and punitive damages. A number of civil actions were subsequently filed against us concerning the matter. We intend to defend these cases vigorously, but there are no assurances as to their outcome.
On or about March 16, 2006, two shareholder derivative actions were initiated against the Board of Directors and certain company officers. The cases involve claims that the defendants failed to properly manage certain company activities resulting in a restatement of financial results due to state tax miscalculations. These cases are pending in the Circuit Court of Jackson County, Missouri and are styledPriscilla Fisk v. Mark A. Ernst, Jeffrey E. Nachbor, William L. Trubeck, Melanie K. Coleman, Frank J. Cotroneo, Thomas M. Bloch, Donna R. Ecton, Henry F. Frigon, Roger W. Hale, Len J. Lauer, David Baker Lewis, Tom D. Seip, Louis W. Smith, Ray Wilkins Jr. and Kenneth Baum. The plaintiff in the second action is Robert Lang. The named defendants in theLang matter are the same as inFisk. We intend to defend these cases vigorously, but there are no assurances as to their outcome.
Subsequent to February 2006, a number of putative class actions alleging violations of certain securities laws were filed. The actions seek unspecified damages and equitable relief. We intend to defend these cases vigorously, but there are no assurances as to its outcome.
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 state attorneys general, individual plaintiffs, and 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, the POM guarantee program and our Express IRA 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, employment matters and contract disputes. We believe we have meritorious defenses to each of the Other Claims, and we are defending them vigorously. While we cannot provide assurance that we will ultimately prevail in each instance, we believe the amount, if any, we are required to pay in the discharge of liabilities or settlements in these Other Claims will not have a material adverse effect on our consolidated financial statements.
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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES
A summary of our purchases of H&R Block common stock during the third quarter of fiscal year 2006 is as follows:
(shares in 000s) | ||||||||||||||||
�� | Total Number of Shares | Maximum Number | ||||||||||||||
Total | Average | Purchased as Part of | of Shares that May | |||||||||||||
Number of Shares | Price Paid | Publicly Announced | Be Purchased Under | |||||||||||||
Purchased(1) | per Share | Plans or Programs(2) | the Plans or Programs(2) | |||||||||||||
November 1 — November 30 | — | $ | — | — | 10,494 | |||||||||||
December 1 — December 31 | 2 | $ | 24.97 | — | 10,494 | |||||||||||
January 1 — January 31 | 11 | $ | 25.50 | — | 10,494 |
(1) | All shares were purchased in connection with the funding of employee income tax withholding obligations arising upon the exercise of stock options or the lapse of restrictions on restricted shares. | |
(2) | On June 9, 2004, our Board of Directors approved the repurchase of 15 million shares of H&R Block, Inc. common stock. This authorization has no expiration date. |
ITEM 6. EXHIBITS
10.1 | Amendment Number One to the Amended and Restated Sale and Servicing Agreement dated November 11, 2005 among Option One Mortgage Corporation, Option One Loan Warehouse Corporation, Option One Owner Trust 2003-5, and Wells Fargo Bank, N.A. | ||
10.2 | Amendment Number Four to the Second Amended and Restated Sale and Servicing Agreement dated March 8, 2005 among Option One Mortgage Corporation, Option One Loan Warehouse Corporation, Option One Owner Trust 2001-2, and Wells Fargo Bank, N.A. | ||
10.3 | Amendment Number Seven to the Amended and Restated Note Purchase Agreement dated November 25, 2003 among Option One Loan Warehouse Corporation, the Option One Owner Trust 2001-2, and Bank of America, N.A. | ||
10.4 | Amendment Number Eight to the Amended and Restated Indenture dated as of November 25, 2003 between Option One Owner Trust 2001-2 and Wells Fargo Bank, N.A. | ||
10.5 | Agreement of Settlement dated December 23, 2005 among H&R Block, Inc., H&R Block Services, Inc., H&R Block Tax Services, Inc., Block Financial Corporation, HRB Royalty, Inc., H&R Block Eastern Enterprises, Inc., Deadra D. Cummins, Ivan and LaDonna Bell, Levon Mitchell, Geral Mitchell, Joyce Green, Lynn Becker, Justin Sevey, Maryanne Hoekman and Renea Griffith.* | ||
10.6 | Sale and Servicing Agreement dated as of December 30, 2005, among Option One Mortgage Corporation, Option One Loan Warehouse Corporation, Option One Owner Trust 2005-9, and Wells Fargo Bank, N.A. | ||
10.7 | Note Purchase Agreement dated as of December 30, 2005, among Option One Loan Warehouse Corporation, Option One Owner Trust 2005-9, DB Structured Products, Inc., Gemini Securitization Corp., LLC, Aspen Funding Corp. and Newport Funding Corp. | ||
10.8 | Indenture dated as of December 30, 2005, between Option One Owner Trust 2005-9 and Wells Fargo Bank, N.A. | ||
31.1 | Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | ||
31.2 | Certification by Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | ||
32.1 | Certification by Chief Executive Officer furnished pursuant to 18 U.S.C. 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002. | ||
32.2 | Certification by Chief Financial Officer furnished pursuant to 18 U.S.C. 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002. |
* | Confidential information has been omitted from this exhibit and filed separately with the Commission pursuant to a confidential treatment request under Rule 24b-2. |
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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.
H&R BLOCK, INC. | ||
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Mark A. Ernst | ||
Chairman of the Board, President | ||
and Chief Executive Officer | ||
March 31, 2006 | ||
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William L. Trubeck | ||
Executive Vice President and | ||
Chief Financial Officer | ||
March 31, 2006 | ||
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Jeffrey E. Nachbor | ||
Senior Vice President and | ||
Corporate Controller | ||
March 31, 2006 |
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