H&R Block, Inc. (HRB) Q3 2011 Earnings Report, Transcript and Summary

Good day, and welcome to today's Web Conference. [Operator Instructions] At this time, we'd like to welcome everyone to today's web event titled H&R Block's Fiscal Year '11 Q3 Earnings Call. It is my pleasure to turn the floor over to Mr. Derek Drysdale. Mr. Drysdale, you have the floor.

Thank you, Kristen. Good afternoon, everyone, and welcome to our Fiscal 2011 Third Quarter Conference Call. I'm joined by Alan Bennett, our President and CEO; Phil Mazzini, President of Retail Tax Services; Jason Houseworth, President of Digital Tax Services; and Jeff Brown, our Chief Financial Officer. In conjunction with today's call, we have posted our accompanying press release and slide presentation to the Investor Relations website at hrblock.com. Before we begin, I'd like to remind everyone that today's remarks will include forward-looking statements as defined under the Securities Exchange Act of 1934. Such statements are based on current information and management's expectations as of this date, and are not guarantees of future performance. Forward-looking statements involve certain risks, uncertainties and assumptions that are difficult to predict. As a result, our actual outcomes and results could differ materially. You can learn more about these risks in the press release we issued earlier this afternoon, our Form 10-K for fiscal 2010 and our other SEC filings. H&R Block undertakes no obligation to publicly update such risk factors or forward-looking statements. Some of the numbers today we will reference are presented on a non-GAAP basis. We have reconciled the comparable GAAP and non-GAAP numbers in today's press release. With that, I will now turn the call over to Alan.

Thank you, Derek, and good afternoon, everyone. As you all know, this tax season started off very slow across the industry. Millions of taxpayers were unable to file their returns prior to February 14 due to IRS delays in processing certain forms. As a result, the first peak of tax season shifted well into February. We estimate total tax filings at the IRS through February 28 were down about 2%, and believe we've gained share both in the retail and online markets. By year end, we estimate total filings at the IRS will be about flat to last year due to sustain high levels of unemployment. We are now more than halfway through the tax season, and I'm very pleased with our performance and execution to date. As you recall, I articulated my top priority heading into this tax season was to stem the significant early season client losses we experienced in each of the last two seasons. Then on December 23, we lost our access to the important RAL product. And as we began the 2011 tax season, we faced the marketplace where our competitors were aggressively advertising their RAL availability to our disadvantage. Despite that challenge, the growth initiatives that we implemented had proved to be effective and our execution is improved considerably. As Phil will explain in more detail, our free federal 1040 EZ offer and a new and more compelling marketing message served to drive more traffic into our offices. For existing clients, our retention to the brand and client satisfaction scores have improved over last year. Our level of new H&R Block client growth is the largest we've seen in at least six years. In Retail, total returns prepared through February 28, grew 3.2% from last year. With respect to our Digital business, as Jason will discuss in more detail, we fulfilled our pre-season promise is simplify our website, which has improved navigation and ease of use. We've leveraged our free offer to drive new clients and have improved our overall digital conversion rates. These actions have been effective through February 28, as we have had nearly 13% growth in total digital returns prepared, including growth of more than 30% in the strategically important online category. As expected, the decline in our retail net average charge, or NAC, has improved by 90 basis points since February 15. Year-to-date, through February 28, the NAC declined by 7%, primarily due to the success of our free federal 1040 EZ offer. Also contributing to the NAC reduction through February was the loss of some Form 1040A clients due to the lack of a RAL product. Excluding our 1040 EZ products from both years, our NAC actually increased by nearly 3%. As we enter into the second half of the season, we should see continued and gradual improvement in the NAC as we serve clients with more complexity, and due to the discontinuation of our EZ promotion which ended February 28. However, primarily due to the strong success of the EZ promotion, we expect a full-year decline in the NAC of two to four percentage points. The EZ promotion was a targeted initiative, which we were able to do because of our financial strength, our scale and our ability to aggressively message this offer. We firmly believe this program will provide a pipeline of new filers to the H&R Block brand for future years, allowing us to monetize these clients as they transition to more complex returns. With the first half of the season now behind us, our focus turns to execution in the second half of the season. To date, I am very pleased with our focused execution, effective marketing and the exceptional service our tax professionals and support staff have provided our clients. However, we still have millions of clients left to serve and we are committed to finishing strong to further improve our market share and better position ourselves for the 2012 tax season. For fiscal 2011, we believe our total retail returns prepared will increase approximately 50 basis points to 150 basis points compared to the prior year. Before I conclude, I'd like to briefly comment on our pending acquisition of TaxACT. The transaction remains under regulatory review, and we have provided additional information as requested by the Department of Justice. The closing date is not yet finalized, but will occur as soon as regulatory approvals are received. Both parties recently agreed to extend the transaction date from April 30 to May 31. With that, I'll now turn the call over to Phil.

Thank you, Alan, and good afternoon. I'll use the next part of the call to accomplish three things: Briefly remind you of the challenges we face entering the season, review the commitments we made to address these challenges and discuss the progress we made in executing against those commitments; progress with which we were quite pleased to date. On the December call, we reviewed several challenges that we faced moving into the season. They were steep, and they became steeper as we moved closer to the season start. They included: First, depressed economic circumstances that impacted our clients, especially our early-season client disproportionately; second, negative momentum from two prior years of substantial first half client losses, which significantly reduced the pool of clients from which we could retain; third, former pen-and-paper filers have increasingly chosen the digital space over the assisted retail space, which has impacted the pool of new clients available to our Retail business; and fourth and finally, threats to our Refund Anticipation Loan business from a challenging regulatory environment. While we thought the scenario of our competitors have RALs and we do not was one possible outcome, we saw this is a worst case scenario. As we know now, that scenario did, in fact, materialize. On the December call, we stated clearly that our strong brand, our superior retail presence, our banking capabilities and most importantly, our rigorously-trained and service-minded tax professionals, all constituted assets we could leverage, and that those assets kept us optimistic regarding the future of our Retail business despite the many challenges we faced. We then shared our plans to improve both our retention fundamentals and our short-term new client growth trends. I will now take a few minutes to review the progress we have made against these plans. On the retention front, we built on our prior year's work and focused on upgrading our front desk presence and personnel, moving our clients to our higher performing tax professionals, and improving our contact center experience to better serve clients during remote touch points. We continue to see strong progress in service delivery from these and other initiatives. Our retention is up over a point from prior year despite our inability to offer RALs. Our overall client satisfaction has again climbed, up nearly two points to date. Virtually all satisfaction measures, including friendly greeting, Cared About Me, confidence in tax professional's knowledge and intent to refer have risen nicely. Our contact center in particular continues to show strong issue resolution and satisfaction gains. Our client calling programs and social media programs have worked to boost our client retention efforts as well. And, of course, as service improves, more clients recommend us to their friends, which brings us to our new client discussion. In December, we highlighted two reasons that we need to address the new client growth area very aggressively. We needed to reverse several years of new client declines, and as referred to earlier, we need to fill a gap left by a declining base of clients available to retain in the first half. We detailed five drivers, including: First, changes to our Emerald Advance program, making it available to new and prior clients; second, a new free 1040 EZ tax professional sampling program; third, our early-season settlement product approach; and fourth, a new national marketing campaign; and fifth, our competitive conversion program. Overall, our new client growth programs have delivered above expectations. Through February 28, we served 25% more new clients than we did last year. As Alan mentioned, this is the highest level of new client growth we've seen in at least six years. Our Emerald Advance pre-season line of credit program exceeded our client growth expectations, as we approved more clients than originally anticipated. We do have higher bad debt associated with this program than originally planned, however, and Jeff will cover this briefly later in the call. Our free 1040 EZ tax professional sampling program has significantly exceeded our client growth expectations. We're delighted that hundreds of thousands of new clients in a younger demographic came in to sample the best trained tax professionals in the country. Given our strong satisfaction scores, we also have confidence that we will see many of them return in future years for more complex tax preparation as well. Retention of these clients will be the longer term determinant of this program's success, as our research indicates that within two years, 55% of these clients will file a more complex tax return. This program did drive our net average charge down in the first half. However, this is more of a function of program volume success than it is our ability to monetize the program. In fact, our monetization plans for this program were in line with expectations. You will recall that our settlement product situation was not certain at the time of our last call. We committed to you, though, that we would use our strengths to compete aggressively in the early season and that whatever our offering, you can expect us to use our scale to promote our product more aggressively than we did in the prior year. Despite these obstacles, we delivered on that commitment. Despite severe obstacles, excuse me. After disappointing and late regulatory outcomes, we relied heavily on our deferred payment RAC product as our early-season driver. Our execution, a strong early season marketing message and our strong tax professional client relationships came through in a big way, and we held on to more settlement product clients than most would have thought possible back in December. Additionally, our Emerald Card offering has held up very nicely despite our RAL situation, highlighting its consumer appeal. Now a quick word about our advertising. As Alan mentioned, we could not be more pleased with our advertising program this year. We asked taxpayers to never settle for less than the best tax professionals in the industry, and they're responding. Our marketing team and agency developed a fantastic campaign. That campaign did not tell consumers about our expertise; it demonstrated it, it demonstrated our expertise with real-life Second Look review experiences. And that proved and continues to prove very powerful. Our campaign also helped drive our free EZ professional sampling program and our RAC program as previously mentioned. And finally, our tax professionals support this campaign as it highlights their expertise and client focus. We believe that this campaign has long-term staying power. Finally, we continue to believe that rising regulatory associated costs and the RAL situation will accelerate consolidation of this fragmented industry. We have accelerated our efforts this year to capitalize on this trend, converting more than 100,000 returns from competitors to H&R Block returns this year. To summarize, we are very pleased with our efforts to improve retention and new client growth. The strength of our brand continues to draw clients seeking the industry's best service and professionals. Before I conclude, though, I'd like to briefly review our net average charge or NAC. You will recall from our December call, that we expected no material change to our overall year end NAC, but also mentioned a number of factors could impact it. In the first half, three factors compounded to reduce our NAC. And I would say these are, in order of importance, from least to most: An IRS associated forms delay issue that impacted the timing in which clients filed more complex and higher value returns; the loss of some RAL clients whose returns typically contain credits that can make them relatively complex; and third, a more successful tax professional sampling program than we anticipated. So I'd like to address each factor. A more complex and higher value business continues to recover post the delay, and we expect complete or near compete recovery by year end. We do not anticipate recovering all of our RAL-related returns, of course, but we held this impact in check in the early-season. In fact, last year, we retained 65% of RAL clients. This year, we retained 63% of RAL clients, and we're quite pleased with that result given our situation. We do not expect to make up the full NAC reduction that our free EZ tax professional program drove. However, we see this stronger than anticipated promotional success as a positive for our current year and our future, and certainly not a negative as it constitutes a near revenue neutral, and very low cost client-acquisition vehicle. Keep in mind, looking forward, that we face none of these NAC challenges in the second half within our current plans. In conclusion, we implemented an aggressive growth plan in the first half of the season. That plan and our service initiatives, which continue to drive up retention and help us overcome an uneven playing field and then some. Our field, marketing and support teams and our franchisees have begun executing our second half initiatives, which focus primarily on inviting clients in to sample the expertise of our tax professionals, with Second Look as our proof point. Early indications on our second half program supported by our national ad campaign and local marketing efforts, indicate continued momentum. Both our Second Looks and return conversion rates are well ahead of last year, giving us increased confidence heading into the remainder of the season. I am fortunate to work with exceptional team members across our company-owned and franchise network, all of whom have helped drive performance in a challenging environment. We remain pleased with our progress, focused on second half performance and service fundamentals and optimistic on our ability to grow this business in the future. I will now turn the call over to Jason.

Thank you, Phil, and good afternoon. As we enter this season, our focus was to outpace the industry growth in online, an area we continue to believe is the primary digital battleground. Year-to-date, we've grown 30% in non-FFA online, and based on these results, it is our belief we have taken share in the online category. Within online, we've seen particularly strong demand for our products from new clients, with an increase of 49%. Even with the influx of new clients, we see modest improvements in product monetization and strong demand for our financial products, with online RACs, or what we call Simple Pay units, up 28%. In software, a category we believe will continue to slowly decline, we are effectively flat, but some of these units have come through additional distribution in a low-cost retailer. This is why we continue to focus on winning in online, an area we view as a more open playing field. Our results this year are a direct outcome from execution around the promises we made for improvement in the following areas: Marketing, the redesign of our website, and simplification of our online product to drive improvement and client conversion. First, in marketing, our goal was to increase brand awareness of the H&R Block At Home products, using attention-grabbing advertising, coupled with a clear File For Free call to action to drive customer acquisition and trial. We also used our advertising to highlight an added feature to all of our products, including our free product, the ability to get worry-free audit support for all customers. Offering this service free to all customers is unique to H&R Block, and represents an offering only a combined retail and software business can deliver profitably. The feedback from our customers and year-over-year web traffic growth of 29% indicate early success for these marketing messages. This year, we were able to better capitalize on this web traffic growth, leveraging our newly redesigned website to turn visitors into customers in the form of registered online users and retail appointments. We not only updated the look to better represent our brand, we also simplified the experience to get customers started in the online product, as well as giving retail clients a clear path to making an appointment. So far this year, retail appointments made from the website are up 92%, a number that not only represents material volume growth, it also represents improved visit-to-appointment conversion. Finally, we improved some key sections of our online product to ensure once we landed a registered client, we turn this client into a completed return. As a result, product conversion rates are up for both new and prior clients. Clearly, the combination of our website and product improvement shows in our early results. Other key quality measures also demonstrate these changes have resonated with clients, with client retention up for new and prior online clients, as well as client satisfaction scores up 3% in both online and software. I am truly pleased to report this strong execution, demonstrate the ability for our brand to resonate and deliver results without coming at the expense of our core retail tax business. I'll now turn the call over to Jeff Brown.

Thanks, Jason. Let me begin by providing a recap of our third quarter results. Today, we reported a $0.01 per share loss from continuing operations. Our current quarter results were not comparable to the prior period due to the number of unusual items. And adjusting for those items, we reported per share earnings for the quarter of $0.14, compared with per share earnings last year of $0.16. Let me briefly outline the adjustments. Each period included asset impairments principally related to goodwill of our business services segment last year and related to our RedGear business unit this quarter. The current quarter impairment totaled approximately $14 million after tax, or about $0.04 per share. As expected, we have experienced some client loss related to early-season settlement product clients. Those clients frequently took advantage of the tax event as a convenient opportunity to pay down outstanding balances under an Emerald line of credit. As a result, we expect to incur higher credit losses this year, and our third quarter loss has exceeded last year by an estimated $13 million after tax, or $0.04 per share. Outstanding loan balances at the end of February remained higher than historical levels, and we will continue to monitor fourth quarter collections and update credit loss assumptions at April 30. As you know, the IRS was not able to accept certain electronically-filed tax returns, primarily involving Schedule A prior to February 14. And we deferred revenue at January 31 of $19.7 million relating to completed returns which could not be e-filed. This revenue was recognized in our fiscal fourth quarter. Finally, we also increased legal reserves within our Tax Services segment this quarter, and the increase reduced earnings by about $0.03 per share. In addition to the revenue deferral, the IRS filing delay impacted current quarter results through changes in taxpayer filing patterns and an extending of our first peek well into the month of February. This is merely a timing difference, and as you can see from today's announcement, volumes in February have been strong. One final thought on how changes in our settlement product offerings this year will impact full-year results. For the full year, we expect settlement products revenues to decline by about $20 million, compared with aggregate revenues last year. This revenue decrease is almost entirely due to a decline in aggregate units and not related to significant pricing differences between products. In addition, costs of terminating the HSBC contract, including contractual payments we have historically received in our fiscal fourth quarter, will adversely impact full year per share earnings by about $0.04. Turning to our mortgage loan portfolio. Mortgage loans held by our bank continue to wind down, and the net principal balance of mortgage loans decreased by about $24 million during the quarter to just over $500 million. Our allowance for loan losses was $88 million at quarter end, or nearly 15% of outstanding principal, compared to $97 million, or 13%, a year ago. A shrinking loan portfolio and moderation of delinquency and loss rates has resulted in reduced loss provisions this year, and year-to-date losses have fallen $12 million compared with the same period last year. We saw no significant changes in rep and warranty claim activity during the quarter. Sand Canyon entered the quarter with open claims that were asserted in the first and second quarters, but had not yet been reviewed in the principal amount of $121 million. In addition, new claims for alleged breaches in the principal amount of $33 million were received during the third quarter. Substantially all of these claims were reviewed during the quarter, and incurred losses were only $4.3 million. We ended the quarter with open claims of $14 million. As expected, payments of approximately $25 million were made during the quarter for previously reserved losses under an April 2008 indemnification agreement. And all remaining obligations under this agreement, totaling $24 million, were paid in our fourth quarter. As a reminder from last quarter's call, this agreement was previously entered into with a single specific counter-party in exchange for a full and complete release of that party's ability to assert rep and warranty claims. At quarter end, Sand Canyon's rep and warranty reserve was $155 million, and the reserve included both the remaining $24 million payable under the indemnification arrangement, and also included $131 million for future probable losses on unasserted claims. Claim activity and associated losses continue to remain within reserved expectations. Finally, our balance sheet and liquidity positions remain strong as we enter our most profitable quarter. We ended the third quarter with nearly $1.5 billion of cash and over $800 million in equity. With the absence of RAL-related short-term borrowings, our short-term debt decreased by more than $1 billion versus last year, to $1.7 billion. Short-term borrowings which peaked at just over $700 million in February were fully repaid in March. And at January 31, 305 million shares were outstanding. And now, I'll turn the call back to Alan.

Thanks, Jeff. I'm very pleased with where we are in this tax season. After losing our RAL product in the 11th hour, we entered this season at a meaningful competitive disadvantage. As a result, many people externally expected us to report significant early-season client and market share losses. Certainly, the loss of RALs has impacted our year in a number of ways. As Jeff pointed out, it triggered the RedGear goodwill impairment charge that we incurred this quarter. It also caused some of our traditional RAL customers to migrate to competitors where we often lost higher revenue from more complex forms. This client loss also caused us to experience higher than anticipated bad debts on our Emerald line of credit product. But our organization is executing consistently to our business plan with excellence. Our organizational alignment to distinct P&Ls, the leadership of our business presidents, and the recasting of individual short-term incentives to more controllable and impactful business drivers has resulted in market share gains at both retail and digital at this interim point. The realignment of the marketing function into the Retail Tax business has ensured that our product and pricing plans are developed in complete coordination with our advertising and marketing. And our advertising is driving new client growth. Our early market share success is heavily driven by simplifying our activities and focusing in executing on fewer, more impactful metrics, and we're operating the business to tighter tolerances. Our organization is improving in execution every day. I am increasingly optimistic about our future. Headwinds can become tailwinds. Total IRS returns should increase in coming years as employment levels improve. A level, financial product marketplace should provide some revenue lift to H&R Block just due to a more traditional mix of tax forms. Our 1040EZ client pipeline gives us a strong customer base to build from, as these filers migrate to more complex returns. Our strong balance sheet, our brand name and significant second half expertise client market share are all positive differentiators. But the most important asset we must continue to demonstrate in any market scenario is our ability to execute. So as we turn our attention to the second half of this year, we must continue to demonstrate our ability to execute with our more complex tax clients, whom we have historically retained at a higher level. We still have a lot of work ahead of us to finish tax season 2011 strongly, and improve our overall market position as we head into tax season 2012. Kristen, we're now ready to take questions.

[Operator Instructions] Your first question is from Kartik Mehta with Northcoast Research.

This is Grant in for Kartik. Clearly, the free 1040EZ program drove taxpayers into the doors. Could you give us some more color on the makeup of those clients? Just what percentage of the 1040EZ clients filed the 1040A form? What percent purchased a state return? And as well as if there's any growth or decline in the non-1040EZ clients that you can provide?

The first part of your question, the percent of EZ clients that what?

Filed a 1040A, came in as a 1040EZ and --

I would say, Grant, that certainly, we had expectations around the program going into it. And we are very close to that expectation in terms of the number of clients that trade up to different forms, and the number of clients that opted to file a state tax return. And I would say, just to sum that up, the number of these that were actually free was right in line with our expectation.

And then any early indication on whether you guys are going to continue this program next season?

I don't think we want to comment on our future strategy for competitive reasons.

Another question, when you guys talked about the advertising, and how that's been a huge success each year, just any color on the amount of the spend on advertising this year compared to last year? Whether that's increased significantly or about in line or?

Yes, I would say that we invested probably at similar levels to slightly higher.

And then real quick, just on the RAL situation, if RALs are completely eliminated for everyone, level playing field, what do you believe the impact is going to be on the independent taxpayer population?

This is Alan, Grant. And thanks for the question. It's hard to -- As we look at -- I think every scenario, there's a scenario that there are no financial products. There's a scenario that there are no RALs. I think there is a number of different ways this can go. I think each of them provides some challenges and everyone some benefits. But I think as we look at this, we are a tax provider, we think we're the best tax provider. People that look like us don't have the second half like we have. I think that we've proven this year that our brand is really a strong brand. We see, I think, as financial products change going forward, there's a likely scenario of people that drop out, people that consolidate. I don't think the business model, without financial products works for everybody. So what I would say is that we see, in a level playing field, terrific advantages for us going forward. I think a natural lift to our NAC on a level playing field as we get more of a normalized mix of state, 1040, and earn income credit type forms that we lost some share on this year. But I think the model doesn't work for everybody. I think the consolidation will be good for us. Change is good for us.

Your next question is from Scott Schneeberger with Oppenheimer. Scott Schneeberger - Oppenheimer & Co. Inc.: First, I guess, I'd like to start off, through February 25, we saw that the filings with the IRS were down 2% year-over-year. You guys are anticipating a flat for the year. Could you speak a bit to what things you've -- how you think we get there?

First of all, our internal guidance, I think on the IRS filings, would be that they would be slightly behind last year. I don't think it will get to flat. My comments at flat or just to make sure we keep the gas pedal on, the people in our field that we continue to look at our own share versus maybe a higher bench. Scott Schneeberger - Oppenheimer & Co. Inc.: So you do think it might be down 1% or something like that, Alan, perhaps?

Actually, our business plan was based on 1% decline in IRS filings. Scott Schneeberger - Oppenheimer & Co. Inc.: And you think that's pretty much still on track?

I think so. Scott Schneeberger - Oppenheimer & Co. Inc.: And this negative 3% at this point, just any thoughts on why this late into the season, it's down as much as it is?

I think the primary driver versus what Alan said in the general economic climate is the delay, the forms delay. There's still recovery going on. Most of the recovery happened by the 25th through the 28th, but there's still some recovery going on. Scott Schneeberger - Oppenheimer & Co. Inc.: Have you seen just this week into March, this momentum continuing that might correspond with that response?

I would say there's only been a handful of days, and I don't think there's anything we can see there that would help this discussion at all. Scott Schneeberger - Oppenheimer & Co. Inc.: And then you guys -- I don't know if I heard it right, but conversion of 100,000 returns from competitors, was that storefront, was that storefront and digital? Did I get the number right? And could you take us a little deeper on what exactly, how you tracked that?

Yes, it is storefront and it's retail. And the majority of that is owners that are independent operators that decide they want to become a Block franchisee for a number of reasons. And they're coming into our network, and we believe will be over 100,000 returns when the year is over. Scott Schneeberger - Oppenheimer & Co. Inc.: So that some people you have converted into your employ as opposed to folks that you've surveyed coming in that said, "I was somewhere else last year. I came to you this year?"

These were people that were. . .

Independent tax businesses that people operated on their own that decided instead of being independent, they would come in and join the H&R Block brand to become a franchisee. Scott Schneeberger - Oppenheimer & Co. Inc.: And did you guys survey this year and get a sense of at the storefront if you might be taking share from others? And any comments there if you did that at all?

We believe from a number of different sources, that our shares are fairly healthy, especially relative to the past. And I'd say with the EZ program, we're very confident that we're in positive territory. And without it, we're probably flat to slightly up. Scott Schneeberger - Oppenheimer & Co. Inc.: One more and then I'll hop back in later, how much do you think of your storefront business, or even your Digital business, was driven by folks that just couldn't get a hold of forms this year? Say your traditional pencil and paper filers, do you think there's an acceleration this year into either of your other channels and then why?

Not really seeing that as a major factor.

Your next question is from Michael Millman with Millman Research Associates.

Since we've talked about the EZ, I guess, I continue, could you tell us how many, or what percentage were EZs this year compared with last year to start?

Let me just say, Michael that we've gotten hundreds of thousands of incremental EZs and we're quite happy with that. I will tell you that the revenue generated from EZs haven't changed much from one year to the next. Certainly, we've had a higher percentage of actual returns generated from EZs in the beginning of the season.

And the people on the street typically suggest that the retention rate for free product is very, very low. Could you talk about, at least in some more detail, how you expect to retain the bulk of these next year?

Michael, our goal with this program is to expose people to tax professionals that we think, that we know are the best trained and certainly can develop relationships. We will be learning a lot about the retention of these clients as we go forward, and that really will be the true determinant of the program. But we're confident, given our satisfaction scores and what we've seen, that we'll retain them at rates that we think are respectable.

This year, even though you didn't have RALs, there were certainly some confusion about whether you had RALs. Next year, there'll be no confusion. The assumption I'm getting to is, in fact, RALs tend to drive people, drive ARs as well, and it looks like next year could be much more competitive on ARs, you look at the relatively high price. Could you talk about what your thinking is regarding ARs and pricing for ARs next year?

I don't think we want to talk about our pricing around our products for next year. Certainly, there are a lot of dynamics that might impact that, but I don't think we want to speculate on that right now.

With half the season to come, your numbers suggest you expect to be flat to down. Why wouldn't you expect to be flat to up for the second half of the season, considering it's not RAL affected?

Yes. Michael, there's a couple of things. There's one thing we are still working through. We're going to work through a little bit of pull forward likely on the EZ program in the second half. We really think that's the major piece. Our 1040 business is fairly healthy, and we expect it to be in line with our expectations.

And on mortgages, to what extent are you involved in this group discussing an agreement with the AGs?

This is Jim Ash, if you can all hear me. We have not been an active participant in that group although we have, on various occasions, dealt with individual state attorney generals.

Your next question is from Vance Edelson with Morgan Stanley.

So you've done a great job overcoming disappointments over the past several months. I guess one continuing disappointment is how long the Justice Department is taking to review TaxACT. Any insight into what the issue is or whether there's a realistic chance that it doesn't get approved?

This is Alan. It's hard to speculate on that. They've asked for lots of information, which has taken us quite a bit of time to accumulate. So that's the biggest part of the delay. And because there's so much information, we've granted them some more time to just review the information. But I don't know if there's any fundamental issues with respect to this. I'm still optimistic about it. We'll see.

And then you're having good success with your own digital operations now. Does that change at all the plan for how you'd operate with TaxACT next year? Or could you just refresh us on those plans?

It won't change things. I think I'd rather just comment kind of on the business that we have right now. We're very pleased with the actions we have taken. I think we did a pretty good diagnosis on our business as to the things we needed to do to drive it. And we were very clear on what those were, and we've executed very, very well on all of them. And it has turned into some good volume gains for us. And we're very happy where we are today. Jason has also gone hard at the cost side of this, too. So we're finding some earnings trajectory consistent with the volumes we're seeing. So we're very happy with the business we have right now.

And any update on covenants or more specifically, the prospects for changing them, and the impact on the ability to buy back shares or to make any other strategic moves to unlock value?

Really, we have no comment to make on that right now. What I would say on this is that our goal here is to really execute well on the second half of this year. We, are at the same time, I'm working with my management team and the board to develop a multi-year strategic plan, which will help us guide really for the 2012 tactical plan, all within the next few months. And we'll have more to say about all of the things that are normally in strategic plans at that time, which would be capital deployment and some of the things that you're referring to, that would be part of that.

And one more for me, not to ask you to look towards next year again, but the government's debit card program, any thoughts on how that changes the landscape? And what the impact might be on H&R Block and others?

Yes. And this is Kathy Barney. I'm the President of the H&R Block Bank. We're very much aware of the U.S. Treasury debit card program that they're doing. We're also aware of the Congressional questions that have been posted about that program back to the U.S. Treasury. We feel like this program is going to be, based upon what the Treasury has said, a very small program. And ours, with the Emerald Card and our plans for the future of the Emerald Card, we have a lot of expertise, a lot of history that we're drawing upon. So we feel like that we've been in the market, we're well established in the market and that our future is very bright going forward in maintaining our leadership in the prepaid card industry.

Your next question is from Mike Grondahl with Northland Capital.

First question is just, if you had to attribute kind of your success in growing tax units again, what one or two items would you attribute it to?

I love broad questions like this because you can pretty much say whatever you want. But the things that I focus on is this is a fairly simple business. It's very hard to get it right. So I think that the most important element of the success here is having clear accountability and responsibility within your operating model. You can't have shared jobs. When I came here in July, we had three retail presidents. Now we have one, and we have very clear responsibility and accountability to that. We have -- When I came, we had -- our bank was run by someone who reported to the CFO. Our Digital business was run by somebody who reported to IT. We moved marketing under retail. We've changed incentives to make the incentives controllable, specific, measurable, actionable. We have clear P&L visibility with each of the P&L owners, and the costs roll under them. They're more direct. They're less attributable. They're activity based. So when you have that kind of a business model, then you start to have accountability, you start to have execution and the measurement that allows you to self-correct. So it sounds like a lot of words, but it's a model that works, and it's working now. We have people in the field that know exactly what their responsibilities are, exactly how they are measured and they're performing very, very well.

And maybe I'll ask you one more broad question then. What most surprised you so far about the tax season once it got started?

Surprised me most about what?

Just the tax season.

This is only my second. I was here in 2007 and 2008, and that was a very unusual year. And this year, first of all, the forms delay. And then not finding out -- we didn't have a RAL three days before the tax season started. And then the tax season in January starting off so slowly. It's been a very worrisome year. And I'm just glad that we put the program -- we didn't change any programs when the RAL was lost. We kept the programs we had. We stayed focused. We didn't jump around and overreact to this. I think it's important to note that even though our NAC's down, the NAC without the EZ is up. It shows that we're not discounting across the board for volume. We're selectively targeting certain segments of the marketplace and leveraging our brand and our marketing expertise to drive incremental units and tax returns and clients in here that will be part of this franchise in years to come. So I think that this has been a very worrisome year with respect to environmental and timing delays. But I'm very, very pleased with where we are right now.

And maybe just lastly, could you expand a little bit on your consolidation comments or the potential for industry consolidation?

Yes. One of the things -- I think it's possible. I make people in here concentrate on things we can control and not speculate on things that may be beneficial. But I think what I would say is that in a heavily financial product-oriented world, there are people out there where the model works. And as the economics of that diminish or go away, I don't see the model being as viable as it is for competitors like us. So that sounds like an advantage for us. I think it will take the form of consolidation or people dropping out. But that's usually a slow process and it's an agonizing process, but I think it's a net plus for us.

Your next question is from Vishnu Lekraj with MorningStar.

Looking here at your online gains, do you believe the market share gains within that segment are due to or from competitors or just grabbing a bigger pie of a growing segment of the market?

Well, this is Jason Houseworth. Thanks for your questions, we do think we've taken just over a point of online share. We use IRS data in order to triangulate the information in order to come up with that. And I can't say exactly who we've taken it from, but we do think that online is growing kind of in the 14% to 15% range, and we're clearly out in front of that. And so we're happy with our progress and we look forward to maintaining that gain that we've had and the momentum into the end of the season.

Looking here at your NAC, when you take out the 10 EZ filers, and you take out some of the new customers you've gained over the tax season, how robust do you believe you can grow that moving forward with some of your base customers or retain customers?

Just so I'm clear, you mean this year or you mean in the future?

Moving forward, yes.

So as Alan mentioned, our NAC right now on non-EZ forms are up for this year, you can expect that. I think going forward, we don't think that our dynamics around pricing have changed that much from the past. We believe that we're -- we do think we have a strength in value proposition from consumer standpoints. So we feel like we're in good shape from a NAC and we can make some strategic choices as we go forward on how we want to manage that.

Say you're putting through more customer service and given greater value to retail tax customer, are you going to offset that by trying to increase the NAC on some of the higher-end type tax returns at a greater rate than what you have done in the past?

This is Alan. As you recall, we've been going up 5%, 6% a year up until 2010. '10 we were flat, lost 1 million units. This year, we're showing a NAC reduction, but as we've proven, it's heavily the 1040EZ promotion. Without that, we're around 3%. What I would say going forward is that we have -- I think one of the best things we've done this year with our marketing is we've made our marketing a very big marketing advertising change, which has made the brand more compelling. It’s focused on the benefits of the work we do, and I think will support some pricing going forward. So I think as I look forward over the next few years, I think we have pricing power. I don't know how much we're going to continue to promote certain things to the extent we don't promote as much, that's a natural lift. And I also think in a level financial product world, we're going to get a natural lift on that because it will get our normal share back of the 1040As that we lost this year that went to RALs, as well as some of the complex forms that are associated with that.

Your next question is from the line of Bill Carcache with Macquarie.

I have just a big picture question. Can you help us understand how you think about the interplay between certainly the growth that you achieved in the number of clients served and then with that, it appears some market share both on the retail and on the digital front? But I'm taking a look at tax. The actual tax preparation fees combined, which also would factor in some of the pricing decreases, can you just help us understand how you think about interplay between the benefit that you get in terms of volume growth from lower pricing, but then the economics that you give up, and just how the interplay between those two effects, your thought process?

Let me just back up a little bit because as I came in here, we had experienced two years in a row of 1 million client loss years. So we've gone from -- when I left here in '08, we had 16 million retail customers. And when I came back, we had 14 million. So when we began to put our plans together, the key -- when you get into kind of a customer spiral like that, we have 71%, 72% retention, it's very difficult to stop client losses in one year. But that's what we tried to do. We said we're going to stop the client losses in one year. Now at that point, remember, we didn't know we didn't have RALs. We thought we still had RALs and, of course, we had our RACs. And we developed a business plan around client acquisitions. So we leveraged our Emerald products in the early market. We had our 1040EZ promotion, which we were going to run through the February 15. And then our next big idea was our Second Look promotion, which was going to be for the second half of the year. And we set our goals and objectives and made the changes to our business model that I articulated before. Then we lost RALs. So we really had -- so your question really is the value proposition between volume and price. So we're trying to make the point here through the narrative that we didn't want to discount across the board. We looked at the segmentations of the market, and we break them into nine different segments, and we said, "Where are we under indexed? Where's our growth opportunity for the future? What are the forms that people use early in their careers? How fast do those simple forms convert to more complex forms?" And we made a strategic approach towards owning the early market and certain forums to build our pipeline of customers in future years. These are generally younger people. They're generally people 18 to 24 years old. They're generally not married. They generally don't own houses yet, but they're beginning their careers. They're beginning to work, and they're heavily sometimes -- they can be digital customers. We view this as people who would migrate to 1040As and then 1040s very quickly through their life spectrum. So the value proposition again, we didn't know we weren't going to have RALs then. We lost some 1040As that have impacted the pricing NAC in a way that we hadn't anticipated at the beginning of the year. But this was a targeted approach that worked. And we felt that the more it worked and the more volume we got, the more pressure on NAC but the more successful the program would be. And that's kind of where we are right now. So as I look at this, looking back, I would say that it was just what we needed at the exact right time, and we've executed it just like we wanted to. The key, I think, that has been brought up before, I think Michael brought it up a minute ago, is how do we retain these customers, how do they progress through the complexity of the forms over life? That will measure the success of this program. That's why I kind of like our business model. I like the fact that we've got the right people in the right chairs with the right incentives to make this happen over the next few years.

Can you give a sense -- you've guided to the NAC declining 2% to 4% compared to the prior year and then also a 0.5% to 1.5% increase in total retail returns. So if we kind of put those two pieces together and we look at net tax preparation fees for the year, can you kind of give us a sense of how that shakes out?

Yes. Really, we would be looking on the tax prep fee revenues to be in the ballpark of down 2%-ish.

And last question is can you give some perspective on whether some of the pricing actions, I guess, how much of the increase in the digital volume was driven by pricing actions?

Well, the thing I would say is that even though we advertise, we message free online tax preparation as kind of the call to action across TV and banner. Our new client growth has been across all forms, the EZ 1040A and the most complex 1040 clients. So what we have seen is that the free is kind of the entry call to action but that's really driving new client growth across the board. And as Alan mentioned, the 30% up in non-FFA online is also -- we see high double-digit pretax earnings growth for the Digital business, although we don't currently break that out.

Your next question is from the line of Mike Turner with Compass Point.

I want to find out more about the Emerald Advance, what pick up you've seen in the usage of the Emerald Advance this year versus last year? And then also maybe how many of those had come back and actually, maybe call it a conversion rate, have done returns through H&R Block? And then I have a follow-up, too.

This is Kathy. Our applications that we took with Emerald Advance have been right in line with our expectations. We were very pleased with the number of new clients that it brought into the offices, as well as our prior clients. The Emerald Advance product continues to be a very strong driver for retention of our tax clients. And so overall, with the number of applications that we took, it continues to be a very steady and good program for -- in that.

Would you maybe comment on what your expectations were?

So we have always taken over 1.5 million applications, and so that's what we experienced again this year.

And then also, I don't know if you could comment or broadly just what you're seeing as far as what consumers are doing with their refunds. I don't know if you see any interesting trends like more people putting money into savings account, or checking accounts. I think it's always interesting to me, the data points you get on the consumer.

Mike, I don't think we have very good visibility on that. I think we've seen fewer people take refunds in checks this year than we have in past years. But really, don't have a lot of visibility in how the money is spent.

And then last, if I may, do you have any thoughts as far as the IRS' plans to address fee splitting? Any anticipation of that or thoughts around that? How that would impact if that's implemented?

I think it's really too early to tell right now. We've seen the same literature you've seen, and I think we're all -- the whole industry, I think, is going to participate in the discussion and have a point -- a part to say about this and it will play out over the next six or seven months.

The only thing that I'll add to that is that we have to keep in mind that there are Americans that are unbanked and underserved. And so you have to have a bank account to be able to do it a fee split and do direct deposits. One of the things that we're doing here is meeting our clients where they're at today and providing traditional products and services that they need and want, and not forcing them into products that they're uncomfortable with.

The only thing I'd add to that would be that based on what we're seeing on some of the statistics, some of the actions taken to reduce some credit card fees and other things that banks have added monthly fees to the checking accounts and bank accounts that it will make the number of unbanked much higher. So what Kathy just described, I think is actually going to be a larger issue going forward.

There are no further questions at this time. I'd like to turn the call back to management for any closing remarks.

Everyone, thank you for joining us today. If you have any follow-up questions, please give us a call in Investor Relations. Thank you very much, and have a great day.

This concludes today's conference. Thank you for your participation. You may now disconnect.