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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, 2005

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

(H&R BLOCK LOGO)

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)

(816) 753-6900
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on February 28, 2005 was 165,256,051 shares.

 
 

 


 

(H&R BLOCK LOGO)

Form 10-Q for the Period Ended January 31, 2005

Table of Contents

             
        Page  
PART I
  Financial Information        
 
           
 
 
Condensed Consolidated Balance Sheets
January 31, 2005 and April 30, 2004
    1  
 
           
 
 
Condensed Consolidated Income Statements
Three and Nine Months Ended January 31, 2005 and 2004
    2  
 
           
 
 
Condensed Consolidated Statements of Cash Flows
Nine Months Ended January 31, 2005 and 2004
    3  
 
           
 
  Notes to Condensed Consolidated Financial Statements     4  
 
           
 
  Management’s Discussion and Analysis of Results of Operations and Financial Condition     18  
 
           
 
  Quantitative and Qualitative Disclosures about Market Risk     39  
 
           
 
  Controls and Procedures     39  
 
           
PART II
  Other Information     40  
 
           
SIGNATURES
        45  

 


 

(H&R BLOCK LOGO)

CONDENSED CONSOLIDATED BALANCE SHEETS
Amounts in thousands, except share amounts
                 
 
    January 31,     April 30,  
    2005     2004  
 
    (Unaudited)          
ASSETS
               
 
               
Cash and cash equivalents
  $ 576,146     $ 1,071,676  
Cash and cash equivalents – restricted
    535,318       545,428  
Receivables from customers, brokers, dealers and clearing organizations, net
    623,225       625,076  
Receivables, net
    1,461,097       347,910  
Prepaid expenses and other current assets
    425,400       371,209  
 
           
Total current assets
    3,621,186       2,961,299  
 
               
Residual interests in securitizations – available-for-sale
    253,531       210,973  
Beneficial interest in Trusts – trading
    131,885       137,757  
Mortgage servicing rights
    147,511       113,821  
Property and equipment, at cost less accumulated depreciation and amortization of $642,536 and $579,535
    327,385       279,220  
Intangible assets, net
    295,260       325,829  
Goodwill, net
    975,850       959,418  
Other assets
    388,513       391,709  
 
           
Total assets
  $ 6,141,121     $ 5,380,026  
 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
 
               
Liabilities:
               
Commercial paper
  $ 1,528,882     $  
Current portion of long-term debt
    25,575       275,669  
Accounts payable to customers, brokers and dealers
    1,035,228       1,065,793  
Accounts payable, accrued expenses and other current liabilities
    503,623       456,167  
Accrued salaries, wages and payroll taxes
    230,251       268,747  
Accrued income taxes
    78,796       405,667  
 
           
Total current liabilities
    3,402,355       2,472,043  
 
               
Long-term debt
    928,529       545,811  
Other noncurrent liabilities
    361,587       465,163  
 
           
Total liabilities
    4,692,471       3,483,017  
 
           
 
               
Stockholders’ equity:
               
Common stock, no par, stated value $.01 per share, 800,000,000 shares authorized, 217,945,398 shares issued at January 31, 2005 and April 30, 2004
    2,179       2,179  
Additional paid-in capital
    581,748       545,065  
Accumulated other comprehensive income
    97,625       57,953  
Retained earnings
    2,670,356       2,781,368  
Less cost of 52,864,620 and 44,849,128 shares of common stock in treasury
    (1,903,258 )     (1,489,556 )
 
           
Total stockholders’ equity
    1,448,650       1,897,009  
 
           
Total liabilities and stockholders’ equity
  $ 6,141,121     $ 5,380,026  
 
           
 

See Notes to Condensed Consolidated Financial Statements

-1-


 

(H&R BLOCK LOGO)

CONDENSED CONSOLIDATED INCOME STATEMENTS
Unaudited, amounts in thousands, except per share amounts

                                 
 
    Three months ended     Nine months ended  
    January 31,     January 31,  
 
    2005     2004     2005     2004  
 
Revenues:
                               
Service revenues
  $ 656,871     $ 572,862     $ 1,195,353     $ 1,053,056  
Gains on sales of mortgage assets, net
    198,302       212,249       564,950       672,204  
Interest income
    46,599       59,328       129,192       149,831  
Other
    130,235       118,391       164,478       151,995  
 
                       
 
    1,032,007       962,830       2,053,973       2,027,086  
 
                       
 
                               
Operating expenses:
                               
Cost of services
    509,104       454,342       1,124,894       991,587  
Interest
    24,927       21,361       65,080       64,457  
Selling, general and administrative
    366,025       312,623       894,054       763,434  
 
                       
 
    900,056       788,326       2,084,028       1,819,478  
 
                       
Operating income (loss)
    131,951       174,504       (30,055 )     207,608  
Other income, net
    19,732       1,616       23,250       4,475  
 
                       
Income (loss) before taxes
    151,683       176,120       (6,805 )     212,083  
Income taxes (benefit)
    59,991       69,394       (2,215 )     83,462  
 
                       
Net income (loss) before cumulative effect of change in accounting principle
    91,692       106,726       (4,590 )     128,621  
 
                               
Cumulative effect of change in accounting principle for multiple deliverable revenue arrangements, less tax benefit of $4,031
                      (6,359 )
 
                       
Net income (loss)
  $ 91,692     $ 106,726     $ (4,590 )   $ 122,262  
 
                       
 
                               
Basic earnings (loss) per share:
                               
Before change in accounting principle
  $ .56     $ .60     $ (.03 )   $ .72  
Cumulative effect of change in accounting principle
                      (.03 )
 
                       
Net income (loss)
  $ .56     $ .60     $ (.03 )   $ .69  
 
                       
 
                               
Diluted earnings (loss) per share:
                               
Before change in accounting principle
  $ .55     $ .59     $ (.03 )   $ .71  
Cumulative effect of change in accounting principle
                      (.04 )
 
                       
Net income (loss)
  $ .55     $ .59     $ (.03 )   $ .67  
 
                       
 
                               
Dividends per share
  $ .22     $ .20     $ .64     $ .58  
 

See Notes to Condensed Consolidated Financial Statements

-2-


 

(H&R BLOCK LOGO)

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited, amounts in thousands

                 
 
Nine months ended January 31,   2005     2004  
 
Cash flows from operating activities:
               
Net income (loss)
  $ (4,590 )   $ 122,262  
Adjustments to reconcile net income (loss) to net cash used in operating activities:
               
Depreciation and amortization
    122,305       122,497  
Accretion of residual interests in securitizations
    (86,618 )     (118,389 )
Impairments of residual interests in securitizations
    8,304       26,048  
Additions to trading securities – residual interests in securitizations
    (115,213 )     (251,585 )
Proceeds from net interest margin transactions, net
    98,743       197,417  
Additions to mortgage servicing rights
    (94,569 )     (64,265 )
Amortization of mortgage servicing rights
    60,879       57,334  
Net change in beneficial interest in Trusts
    5,872       (5,406 )
Other, net of acquisitions
    (1,580,364 )     (1,087,553 )
 
           
Net cash used in operating activities
    (1,585,251 )     (1,001,640 )
 
           
 
               
Cash flows from investing activities:
               
Cash received from residual interests in securitizations
    100,344       127,997  
Purchases of property and equipment, net
    (137,483 )     (81,178 )
Payments made for business acquisitions, net of cash acquired
    (26,348 )     (280,280 )
Other, net
    15,207       36,052  
 
           
Net cash used in investing activities
    (48,280 )     (197,409 )
 
           
 
               
Cash flows from financing activities:
               
Repayments of commercial paper
    (2,348,966 )     (1,022,716 )
Proceeds from issuance of commercial paper
    3,877,848       2,433,893  
Repayments of Senior Notes
    (250,000 )      
Proceeds from issuance of Senior Notes, net
    395,221        
Proceeds from securitization financing
          50,100  
Repayments of securitization financing
          (50,100 )
Payments on acquisition debt
    (19,462 )     (50,820 )
Dividends paid
    (106,422 )     (103,538 )
Acquisition of treasury shares
    (529,852 )     (371,242 )
Proceeds from issuance of common stock
    119,892       111,155  
Other, net
    (258 )     (1,947 )
 
           
Net cash provided by financing activities
    1,138,001       994,785  
 
           
 
               
Net decrease in cash and cash equivalents
    (495,530 )     (204,264 )
Cash and cash equivalents at beginning of the period
    1,071,676       875,353  
 
           
Cash and cash equivalents at end of the period
  $ 576,146     $ 671,089  
 
           
 

See Notes to Condensed Consolidated Financial Statements

-3-


 


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Unaudited

1.   Basis of Presentation

The condensed consolidated balance sheet as of January 31, 2005, the condensed consolidated income statements for the three and nine months ended January 31, 2005 and 2004, and the condensed consolidated statements of cash flows for the nine months ended January 31, 2005 and 2004 have been prepared by the Company, without audit. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows at January 31, 2005 and for all periods presented have been made.

     “H&R Block,” “the Company,” “we,” “our” and “us” are used interchangeably to refer to H&R Block, Inc. or to H&R Block, Inc. and its subsidiaries, as appropriate to the context.

     Certain reclassifications have been made to prior year amounts to conform to the current year presentation. Most notably, we reclassified $57.6 million and $125.9 million previously reported as interest income to gains on sales of mortgage assets for the three and nine months ended January 31, 2004, respectively. These reclassifications had no effect on our results of operations or stockholders’ equity as previously reported.

     Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in our April 30, 2004 Annual Report to Shareholders on Form 10-K and our October 31, 2004 and July 31, 2004 Forms 10-Q.

     Operating revenues of the Tax Services and Business Services segments are seasonal in nature with peak revenues occurring in the months of January through April. Therefore, results for interim periods are not indicative of results to be expected for the full year.

     We file our Federal and state income tax returns on a calendar year basis. The condensed consolidated income statements reflect the effective tax rates expected to be applicable for the respective full fiscal years.

2.   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     Nine months ended  
    January 31,     January 31,  
 
    2005     2004     2005     2004  
 
Net income (loss) before change in accounting principle
  $ 91,692     $ 106,726     $ (4,590 )   $ 128,621  
 
                       
 
Basic weighted average common shares
    164,520       176,732       165,948       177,964  
Potential dilutive shares from stock options and restricted stock
    2,917       4,251             3,516  
Convertible preferred stock
    1       1             1  
 
                       
Dilutive weighted average common shares
    167,438       180,984       165,948       181,481  
 
                       
 
Earnings (loss) per share before change in accounting principle:
                               
Basic
  $ .56     $ .60     $ (.03 )   $ .72  
Diluted
    .55       .59       (.03 )     .71  
 

     Diluted earnings per share excludes the impact of shares of common stock issuable upon the lapse of certain restrictions or the exercise of options to purchase 15.2 million shares of stock for the nine months ended January 31, 2005, as the effect would be antidilutive due to the net loss recorded during the period. Diluted earnings per share for the three months ended January 31, 2005 and the three and nine months ended January 31, 2004 excludes the impact of 0.3 million, 283 and 3.7 million shares, respectively, issuable upon the exercise of stock options, as the effect would be antidilutive due to the

-4-


 

options’ exercise prices being greater than the average market price of the common shares during the period.

The weighted average shares outstanding for the three and nine months ended January 31, 2005 decreased to 164.5 million and 165.9 million, respectively, from 176.7 million and 178.0 million last year, respectively, primarily due to our purchases of treasury shares. The effect of these purchases was partially offset by the issuance of treasury shares related to our stock-based compensation plans.

     During the nine months ended January 31, 2005 and 2004, we issued 3.3 million shares and 3.8 million shares, respectively, of common stock pursuant to the exercise of stock options, employee stock purchases and awards of restricted shares, in accordance with our stock-based compensation plans.

     During the nine months ended January 31, 2005, we acquired 11.3 million shares of our common stock, of which 11.2 million shares were purchased from third parties with the remaining shares swapped or surrendered to us, at an aggregate cost of $529.9 million. During the nine months ended January 31, 2004, we acquired 7.8 million shares of our common stock from third parties at an aggregate cost of $371.2 million.

3.   Receivables
 
    Receivables consist of the following:

                         
    (in 000s)  
 
    January 31, 2005     January 31, 2004     April 30, 2004  
 
Participation in refund anticipation loans (RALs)
  $ 829,325     $ 562,974     $ 49,047  
Business Services accounts receivable
    175,140       153,322       145,231  
Mortgage loans held for sale
    128,607       113,388       64,136  
Receivables for tax-related fees
    108,331       79,287       4,900  
Loans to franchisees
    52,712       46,729       35,872  
Royalties from franchisees
    46,900       39,898       725  
Software receivables
    26,420       25,995       20,882  
Other
    126,643       111,801       80,535  
 
                 
 
    1,494,078       1,133,394       401,328  
Allowance for doubtful accounts
    (21,336 )     (23,903 )     (38,266 )
Lower of cost or market adjustment – mortgage loans
    (11,645 )     (16,440 )     (15,152 )
 
                 
 
  $ 1,461,097     $ 1,093,051     $ 347,910  
 
                 
 

4.   Mortgage Banking Activities
 
    Activity related to available-for-sale residual interests in securitizations consists of the following:

                 
    (in 000s)  
 
Nine months ended January 31,   2005     2004  
 
Balance, beginning of period
  $ 210,973     $ 264,337  
Additions from net interest margin (NIM) transactions
    16,470       1,604  
Cash received
    (100,344 )     (127,997 )
Cash received from sale of previously securitized residuals
          (17,000 )
Accretion
    86,618       118,389  
Impairments of fair value
    (8,304 )     (26,048 )
Other
    (4 )     (5,875 )
Changes in unrealized holding gains arising during the period, net
    48,122       26,441  
 
           
Balance, end of period
  $ 253,531     $ 233,851  
 
           
 

     We sold $21.7 billion and $16.9 billion of mortgage loans in whole loan sales to warehouse trusts (Trusts) or other buyers during the nine months ended January 31, 2005 and 2004, respectively, with gains totaling $544.4 million and $685.5 million, respectively, recorded on these sales.

     Trading residual interests valued at $115.2 million and $199.0 million were securitized in NIM transactions during the nine months ended January 31, 2005 and 2004, respectively, with net cash proceeds of $98.7 million and $197.4 million received, respectively. In the prior year, additional residual interests were sold and cash proceeds of $50.1 million were received as a result of a secured financing (on-balance sheet securitization). During the third quarter of last year, the NIM trust was terminated and the related residual interests were subsequently securitized in a NIM transaction with a qualifying

-5-


 

special purpose entity (QSPE). Total net additions to residual interests from NIM transactions for the nine months ended January 31, 2005 and 2004 were $16.5 million and $1.6 million, respectively.

     Cash flows of $100.3 million and $128.0 million were received from the securitization trusts for the nine months ended January 31, 2005 and 2004, respectively. Cash received on residual interests is included in investing activities in the condensed consolidated statements of cash flows.

     Aggregate net unrealized gains on residual interests, which had not yet been accreted into income, totaled $160.4 million at January 31, 2005 and $112.5 million at April 30, 2004. These unrealized gains are recorded net of deferred taxes in other comprehensive income, and may be recognized in income in future periods either through accretion or upon further securitization or sale of the related residual interest.

     Activity related to mortgage servicing rights (MSRs) consists of the following:

                 
    (in 000s)  
 
Nine months ended January 31,   2005     2004  
 
Balance, beginning of period
  $ 113,821     $ 99,265  
Additions
    94,569       64,265  
Amortization
    (60,879 )     (57,334 )
 
           
Balance, end of period
  $ 147,511     $ 106,196  
 
           
 

     Estimated amortization of MSRs for fiscal years 2005 through 2009 is $84.6 million, $70.2 million, $35.4 million, $13.8 million and $3.6 million, respectively.

     The key assumptions we used to estimate the cash flows and values of the residual interests initially recorded during the three months ended January 31, 2005 and 2004 are as follows:

                 
 
    January 31, 2005   January 31, 2004
 
Estimated credit losses
    2.42 %     4.72 %
Discount rate
    25 %     21 %
Variable returns to third-party beneficial interest holders
  LIBOR forward curve at closing
 

     The key assumptions we used to estimate the cash flows and values of the residual interests and MSRs at January 31, 2005 and April 30, 2004 are as follows:

                 
 
             January 31, 2005   April 30, 2004
 
Estimated credit losses – residual interests
    3.08 %     4.16 %
Discount rate – residual interests
    20.37 %     19.09 %
Discount rate – MSRs
    12.80 %     12.80 %
Variable returns to third-party beneficial interest holders
  LIBOR forward curve at valuation date
 

     We originate both adjustable and fixed rate mortgage loans. A key assumption used to estimate the cash flows and values of the residual interests is average annualized prepayment speeds. Prepayment speeds include voluntary prepayments, involuntary prepayments and scheduled principal payments. For adjustable rate mortgages with prepayment penalties, we use an average prepayment rate of 29% in the months prior to the rate reset date, which increases to 74% in the three months immediately following the rate reset date, then subsequently declines to 50% over the remaining life of the loans. For adjustable rate mortgages without prepayment penalties, we use an average prepayment rate of 37% in the months prior to the rate reset date, which increases to 56% in the three months immediately following the rate reset date, then subsequently declines to 46% over the remaining life of the loans.

     For fixed rate mortgages with prepayment penalties, we use an average prepayment rate of 30% during the months prior to the expiration of the prepayment penalties, which increases to 44% in the three months immediately following the expiration date, and remains constant at 45% over the remaining life of the loans. For fixed rate mortgages without prepayment penalties, we use an average prepayment rate of 35% over the life of the loans. Prepayment rate is projected based on actual paydown including voluntary, involuntary and scheduled principal payments.

-6-


 

     Expected static pool credit losses are as follows:

                                         
 
    Mortgage Loans Securitized in Fiscal Year  
 
    Prior to 2002     2002     2003     2004     2005  
 
As of:
                                       
April 30, 2004
    4.46 %     3.58 %     4.35 %     3.92 %      
July 31, 2004
    4.58 %     2.96 %     2.47 %     2.59 %      
October 31, 2004
    4.54 %     2.96 %     2.30 %     2.62 %     3.08 %
January 31, 2005
    4.54 %     2.57 %     2.10 %     2.42 %     2.73 %

     Static pool credit losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets outstanding at January 31, 2005, October 31, 2004, July 31, 2004 and April 30, 2004.

     At January 31, 2005, the sensitivities of the current fair value of the residual interests and MSRs to 10% and 20% adverse changes in the above key assumptions are as follows:

                         
    (dollars in 000s)  
 
    Residential Mortgage Loans        
 
    NIM     Beneficial Interest     Servicing  
    Residuals     in Trusts     Asset  
 
Carrying amount/fair value
  $ 253,531     $ 131,885     $ 147,511  
Weighted average remaining life (in years)
    1.2       2.3       1.2  
 
Prepayments (including defaults):
                       
Adverse 10% – $impact on fair value
  $ 62     $ (10,323 )   $ (21,253 )
Adverse 20% – $impact on fair value
    6,717       (16,485 )     (37,045 )
 
Credit losses:
                       
Adverse 10% – $impact on fair value
  $ (35,301 )   $ (5,418 )   Not applicable
Adverse 20% – $impact on fair value
    (69,779 )     (10,830 )   Not applicable
 
Discount rate:
                       
Adverse 10% – $impact on fair value
  $ (5,600 )   $ (3,084 )   $ (1,919 )
Adverse 20% – $impact on fair value
    (10,946 )     (8,827 )     (3,795 )
 
Variable interest rates (LIBOR forward curve):
                       
Adverse 10% – $impact on fair value
  $ (7,802 )   $ (25,547 )   Not applicable
Adverse 20% – $impact on fair value
    (15,295 )     (51,073 )   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.

     Mortgage loans that have been securitized at January 31, 2005 and April 30, 2004, past due sixty days or more and the related credit losses incurred are presented below:

                                                 
    (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  
    2005     2004     2005     2004     January 31, 2005     April 30, 2004  
 
Securitized mortgage loans
  $ 11,863,950     $ 15,732,953     $ 1,190,385     $ 1,286,069     $ 110,374     $ 46,606  
Mortgage loans in warehouse Trusts
    5,243,654       3,244,141                          
 
                                   
Total loans
  $ 17,107,604     $ 18,977,094     $ 1,190,385     $ 1,286,069     $ 110,374     $ 46,606  
 
                                   
 

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5.   Goodwill and Intangible Assets

Changes in the carrying amount of goodwill for the nine months ended January 31, 2005, consist of the following:

                                 
    (in 000s)  
 
    April 30, 2004     Additions     Other     January 31, 2005  
 
Tax Services
  $ 350,044     $ 9,512     $ 557     $ 360,113  
Mortgage Services
    152,467                   152,467  
Business Services
    311,175       6,365       (2 )     317,538  
Investment Services
    145,732                   145,732  
 
                       
Total goodwill
  $ 959,418     $ 15,877     $ 555     $ 975,850  
 
                       
 

     We test goodwill for impairment annually at the beginning of our fourth quarter, or more frequently if events occur indicating it is more likely than not the fair value of a reporting unit’s net assets has been reduced below its carrying value. No such impairment or events indicating impairment were identified within any of our segments during the nine months ended January 31, 2005. Our evaluation of impairment is dependent upon various assumptions, including assumptions regarding projected operating results and cash flows of reporting units. Actual results could differ materially from our projections and those differences could alter our conclusions regarding the fair value of a reporting unit and its goodwill.

     Intangible assets consist of the following:

                                                 
    (in 000s)  
 
            January 31, 2005                     April 30, 2004        
 
    Gross                     Gross              
    Carrying     Accumulated             Carrying     Accumulated        
    Amount     Amortization     Net     Amount     Amortization     Net  
 
Tax Services:
                                               
Customer relationships
  $ 23,717     $ (5,998 )   $ 17,719     $ 19,011     $ (3,377 )   $ 15,634  
Noncompete agreements
    17,677       (10,098 )     7,579       17,364       (5,724 )     11,640  
Business Services:
                                               
Customer relationships
    125,780       (65,572 )     60,208       121,229       (56,313 )     64,916  
Noncompete agreements
    27,515       (10,619 )     16,896       27,424       (8,670 )     18,754  
Trade name – amortizing
    1,450       (978 )     472       1,450       (926 )     524  
Trade name – non-amortizing
    55,637       (4,868 )     50,769       55,637       (4,868 )     50,769  
Investment Services:
                                               
Customer relationships
    293,000       (151,383 )     141,617       293,000       (129,408 )     163,592  
 
                                   
Total intangible assets
  $ 544,776     $ (249,516 )   $ 295,260     $ 535,115     $ (209,286 )   $ 325,829  
 
                                   
 

     Amortization of intangible assets for the three and nine months ended January 31, 2005 was $13.6 million and $40.4 million, respectively. Amortization of intangible assets for the three and nine months ended January 31, 2004 was $15.3 million and $39.3 million, respectively. Estimated amortization of intangible assets for fiscal years 2005 through 2009 is $54.8 million, $53.3 million, $44.2 million, $42.3 million and $40.9 million, respectively.

     The goodwill and intangible assets previously included in the Corporate segment as of April 30, 2004 have been reclassified to the Tax Services segment.

6.   Derivative Instruments

A summary of our derivative instruments as of January 31, 2005 and April 30, 2004, and gains or losses incurred during the three and nine months ended January 31, 2005 and 2004 follows. We enter into derivative instruments to reduce risks relating to mortgage loans we originate and sell, and therefore all gains or losses are included in gains on sales of mortgage assets, net in the condensed consolidated income statements.

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    (in 000s)  
 
    Asset (Liability) Balance at     Gain (Loss) in the Three     Gain (Loss) in the Nine  
    January 31,     April 30,     Months Ended January 31,     Months Ended January 31,  
    2005     2004     2005     2004     2005     2004  
 
Interest rate swaps
  $ 1,752     $     $ 31,039     $ (2,703 )   $ 28,934     $ (2,703 )
Rate-lock equivalents
    455       (1,386 )     141       (4,525 )     1,841       (3,911 )
Prime short sales
    (319 )     2,080       (424 )     (496 )     (1,949 )     2,317  
 
                                   
 
  $ 1,888     $ 694     $ 30,756     $ (7,724 )   $ 28,826     $ (4,297 )
 
                                   
 

     We use interest rate swaps and forward loan sale commitments to reduce interest rate risk associated with non-prime loans. We generally enter into interest rate swap arrangements related to existing loan applications with rate-lock commitments and, beginning at the end of our second quarter, for rate-lock commitments we expect to make in the next 30 days. Interest rate swaps represent an agreement to exchange interest rate payments, effectively converting our fixed financing costs into a floating rate. These contracts increase in value as rates rise and decrease in value as rates fall.

     Forward loan sale commitments for non-prime loans are not considered derivative instruments and are therefore not recorded in our financial statements. The notional value and the contract value of the forward commitments at January 31, 2005 were $4.0 billion and $4.1 billion, respectively. Most of our forward commitments give us the option to under- or over-deliver by five to ten percent.

     In the normal course of business, we enter into commitments with our customers to fund prime mortgage loans for specified periods of time at “locked-in” interest rates. These derivative instruments represent commitments (rate-lock equivalents) to fund prime loans. We adopted SEC Staff Accounting Bulletin No. 105, “Application of Accounting Principles to Loan Commitments,” as of March 31, 2004. Upon adoption, we no longer record an asset at the time we enter into the commitments to fund non-prime mortgage loans.

     We sell short FNMA, FHLMC and GNMA mortgage-backed securities to reduce our risk related to our commitments to fund fixed-rate prime loans. The position on certain or all of the fixed-rate mortgage loans is closed approximately 10-15 days prior to standard Public Securities Association (PSA) settlement dates.

7.   Long-Term Debt

In August 2004 we filed an additional shelf registration statement with the SEC for up to $1.0 billion in debt securities. On October 26, 2004, we issued $400.0 million of 5.125% Senior Notes under shelf registration statements. The Senior Notes are due on October 30, 2014, and are not redeemable by the bondholders prior to maturity. The proceeds from the notes were used to repay our $250.0 million in 6 3/4% Senior Notes, which were due on November 1, 2004. The remaining proceeds were used for working capital, capital expenditures, repayment of other debt and other general corporate purposes.

8.   Comprehensive Income

The components of comprehensive income are:

                                 
    (in 000s)  
 
    Three months ended     Nine months ended  
    January 31,     January 31,  
 
    2005     2004     2005     2004  
 
Net income (loss)
  $ 91,692     $ 106,726     $ (4,590 )   $ 122,262  
Change in unrealized gain on marketable securities, net
    (3,881 )     (8,356 )     29,714       5,680  
Change in foreign currency translation adjustments
    1,917       2,319       9,958       14,049  
 
                       
Comprehensive income
  $ 89,728     $ 100,689     $ 35,082     $ 141,991  
 
                       
 

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

-9-


 

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     Nine months ended  
    January 31,     January 31,  
 
    2005     2004     2005     2004  
 
Net income (loss) as reported
  $ 91,692     $ 106,726     $ (4,590 )   $ 122,262  
Add: Stock-based compensation expense included in reported net income (loss), net of related tax effects
    8,918       4,733       17,260       7,530  
Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects
    (11,599 )     (7,132 )     (25,304 )     (17,763 )
 
                       
Pro forma net income (loss)
  $ 89,011     $ 104,327     $ (12,634 )   $ 112,029  
 
                       
Basic earnings (loss) per share:
                               
As reported
  $ .56     $ .60     $ (.03 )   $ .69  
Pro forma
    .54       .59       (.08 )     .63  
Diluted earnings (loss) per share:
                               
As reported
  $ .55     $ .59     $ (.03 )   $ .67  
Pro forma
    .53       .58       (.08 )     .62  
 

10.   Supplemental Cash Flow Information

During the nine months ended January 31, 2005, we paid $406.6 million and $53.6 million for income taxes and interest, respectively. During the nine months ended January 31, 2004, we paid $245.4 million and $57.5 million for income taxes and interest, respectively.

     The following transactions were treated as non-cash investing activities in the condensed consolidated statement of cash flows:

                 
    (in 000s)  
 
Nine months ended January 31,   2005     2004  
 
Residual interest mark-to-market
  $ 98,713     $ 24,731  
Additions to residual interests
    16,470       1,604  
 

11.   Commitments and Contingencies

We maintain unsecured committed lines of credit (CLOCs) to support our commercial paper program and for general corporate purposes. During the second quarter, we replaced our $2.0 billion CLOC with two CLOCs. The two CLOCs are from a consortium of thirty-one banks. The first $1.0 billion CLOC is subject to annual renewal in August 2005, has a one-year term-out provision with a maturity date in August 2006 and has an annual facility fee of ten basis points per annum. The second $1.0 billion CLOC has a maturity date of August 2009 and has an annual facility fee of twelve basis points per annum. We obtained an additional $750.0 million line of credit for the period of January 26 to February 25, 2005 to back-up peak commercial paper issuance or use as an alternate source of funding for RAL participations. These lines are subject to various affirmative and negative covenants, including a minimum net worth covenant. These CLOCs were undrawn at January 31, 2005.

     We offer guarantees under our Peace of Mind (POM) program to tax clients whereby we will assume the cost of additional taxes attributable to tax return preparation errors for which we are responsible. In August 2003, we adopted Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21). EITF 00-21 impacts revenue and expense recognition related to tax preparation in our premium tax offices where POM guarantees are included in the price of a completed tax return. Prior to the adoption of EITF 00-21, revenues and expenses related to POM guarantees at premium offices were recorded in the same period as tax preparation revenues. Beginning May 1, 2003, revenues and direct expenses related to POM guarantees are now initially deferred and recognized over the guarantee period based upon historic and actual payment of claims. As a result of the adoption of EITF 00-21, we recorded a cumulative effect of a change in accounting principle of $6.4 million, net of a tax benefit of $4.0 million, as of May 1, 2003. Changes in the deferred revenue liability are as follows:

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    (in 000s)  
 
Nine months ended January 31,   2005     2004  
 
Balance, beginning of period
  $ 123,048     $ 49,280  
Amounts deferred for new guarantees issued
    19,925       19,098  
Revenue recognized on previous deferrals
    (52,295 )     (47,273 )
Adjustment resulting from change in accounting principle
          61,487  
 
           
Balance, end of period
  $ 90,678     $ 82,592  
 
           
 

     We have commitments to fund mortgage loans to customers as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. The commitments to fund loans amounted to $3.2 billion and $2.6 billion at January 31, 2005 and April 30, 2004, respectively. External market forces impact the probability of commitments being exercised, and therefore, total commitments outstanding do not necessarily represent future cash requirements.

     We have entered into whole loan sale agreements with investors in the normal course of business, which include standard representations and warranties customary to the mortgage banking industry. Violations of these representations and warranties may require us to repurchase loans previously sold. A liability has been established related to the potential loss on repurchase of loans previously sold of $36.9 million and $25.2 million at January 31, 2005 and April 30, 2004, respectively, based on historical experience. Repurchased loans are normally sold in subsequent sale transactions.

     Option One Mortgage Corporation provides a guarantee up to a maximum amount equal to approximately 10% of the aggregate principal balance of mortgage loans held by the Trusts before ultimate disposition of the loans. This guarantee would be called upon in the event adequate proceeds were not available from the sale of the mortgage loans to satisfy the payment obligations of the Trusts. No losses have been sustained on this commitment since its inception. The total principal amount of Trust obligations outstanding as of January 31, 2005 and April 30, 2004 was $5.3 billion and $3.2 billion, respectively. The fair value of mortgage loans held by the Trusts as of January 31, 2005 and April 30, 2004 was $5.4 billion and $3.3 billion, respectively.

     We have various contingent purchase price obligations in connection with prior acquisitions. In many cases, contingent payments to be made in connection with these acquisitions are not subject to a stated limit. We estimate the potential payments (undiscounted) total approximately $5.6 million and $7.8 million as of January 31, 2005 and April 30, 2004, respectively. Our estimate is based on current financial conditions. Should actual results differ materially from our assumptions, the potential payments will differ from the above estimate. Such payments, if and when paid, would be recorded as additional cost of the acquired business, generally goodwill.

     We have contractual commitments to fund certain franchises requesting draws on Franchise Equity Lines of Credit (FELCs). Our commitment to fund FELCs as of January 31, 2005 and April 30, 2004 totaled $69.1 million and $27.0 million, respectively. We have a receivable of $52.7 million and $35.9 million, which represents the amounts drawn on the FELCs, as of January 31, 2005 and April 30, 2004, respectively.

     We routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees, including obligations to protect counter parties from losses arising from the following: (a) tax, legal and other risks related to the purchase or disposition of businesses; (b) penalties and interest assessed by Federal and state taxing authorities in connection with tax returns prepared for clients; (c) indemnification of our directors and officers; and (d) third-party claims relating to various arrangements in the normal course of business. Typically, there is no stated maximum payment related to these indemnifications, and the term of indemnities may vary and in many cases is limited only by the applicable statute of limitations. The likelihood of any claims being asserted against us and the ultimate liability related to any such claims, if any, is difficult to predict. While we cannot provide assurance that such claims will not be successfully asserted, we believe the fair value of these guarantees and indemnifications is not material as of January 31, 2005.

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12.   Litigation Commitments and Contingencies

We have been involved in a number of class actions and putative class action cases since 1990 regarding our RAL programs. These cases are based on a variety of legal theories and allegations. These theories and allegations include, among others, that (i) we improperly did not disclose license fees we received from RAL lending banks for RALs they make to our clients, (ii) we owe and breached a fiduciary duty to our clients, and (iii) the RAL program violates laws such as state credit service organization laws and the federal Racketeer Influenced and Corrupt Organizations (RICO) Act. Although we have successfully defended many RAL cases, we incurred a substantial pretax expense in fiscal year 2003 in connection with the settlement of one RAL case. Several of the RAL cases are still pending and the amounts claimed in some of them are very substantial. We cannot estimate the range of possible loss relating to the RAL cases in light of various legal uncertainties. However, it is reasonably possible that the ultimate cost of this litigation could be substantial. We intend to continue defending the RAL cases vigorously, although there are no assurances as to their outcome.

     We are also parties to claims and lawsuits pertaining to our electronic tax return filing services and our POM guarantee program associated with income tax preparation services. These claims and lawsuits include actions by individual plaintiffs, as well as cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. We intend to continue defending these cases vigorously, although there are no assurances as to their outcome.

     In addition to the aforementioned types of cases, we are parties to claims and lawsuits that we consider to be ordinary, routine disputes incidental to our business (Other Claims and Lawsuits), including claims and lawsuits concerning the preparation of customers’ income tax returns, the fees charged customers for various services, investment products, relationships with franchisees, contract disputes and civil actions, arbitrations, regulatory inquiries and class actions arising out of our business as a broker-dealer and as a servicer of mortgage loans. We believe we have meritorious defenses to each of the Other Claims and Lawsuits and we are defending, or intend to defend, them vigorously. While we cannot provide assurance that we will ultimately prevail in each instance, we believe that amounts, if any, required to be paid by us in the discharge of liabilities or settlements pertaining to Other Claims and Lawsuits will not have a material adverse effect on our consolidated financial statements. Regardless of outcome, claims and litigation can adversely affect us due to defense costs, diversion of management and publicity related to such matters.

     It is our policy to accrue for amounts related to legal matters if it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Many of the various legal proceedings are covered in whole, or in part, by insurance. Any receivable for insurance recoveries is recorded separate from the corresponding litigation reserve, and only if recovery is determined to be probable. Receivables for insurance recoveries at January 31, 2005 were immaterial.

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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,  
 
    2005     2004     2005     2004  
 
Revenues:
                               
Tax Services
  $ 531,086     $ 474,495     $ 655,639     $ 586,760  
Mortgage Services
    304,643       317,599       854,410       950,361  
Business Services
    132,872       112,293       371,021       319,816  
Investment Services
    62,104       57,753       169,446       167,443  
Corporate
    1,302       690       3,457       2,706  
 
                       
 
  $ 1,032,007     $ 962,830     $ 2,053,973     $ 2,027,086  
 
                       
Pretax income (loss):
                               
Tax Services
  $ 64,337     $ 61,827     $ (182,624 )   $ (168,136 )
Mortgage Services
    111,681       154,476       311,421       502,331  
Business Services
    5,936       1,955       (9,048 )     (7,456 )
Investment Services
    (18,312 )     (12,811 )     (61,149 )     (41,904 )
Corporate
    (11,959 )     (29,327 )     (65,405 )     (72,752 )
 
                       
Income (loss) before taxes
  $ 151,683     $ 176,120     $ (6,805 )   $ 212,083  
 
                       
 

     Our international operations contributed $12.5 million and $40.6 million in revenues for the three and nine months ended January 31, 2005, respectively, and $8.3 million and $14.7 million in pretax losses, respectively. Our international operations contributed $10.8 million and $35.4 million in revenues for the three and nine months ended January 31, 2004, respectively, and $6.4 million and $12.3 million in pretax losses, respectively. The previously reported International Tax Operations segment has been aggregated with U.S. Tax Operations in the Tax Services segment, and prior year results have been restated to reflect this change.

     The pretax loss from our Corporate segment for the three and nine months ended January 31, 2005 includes a non-operating gain of $16.7 million, or $0.06 per diluted share, resulting from a legal recovery.

14.   New Accounting Pronouncements

In December 2004, Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (SFAS 123R) was issued. SFAS 123R revises the original SFAS 123 on stock-based compensation primarily by requiring all entities to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards. Compensation expense must be recognized for the unvested portions of all awards outstanding as of the date of adoption. The provisions of this standard are effective as of the beginning of our second quarter of fiscal year 2006. We are currently evaluating what effect the adoption of SFAS 123R will have on our consolidated financial statements.

     In October 2004, the American Jobs Creation Act (the Act) was signed into law. The Act introduces a one-time deduction for dividends received from the repatriation of certain foreign earnings, provided certain criteria are met. We have begun our evaluation of the effects of the Act, but do not expect to be able to complete this evaluation until additional clarifying language on key elements of the Act are issued. As of January 31, 2005, we have not provided deferred taxes on foreign earnings because we intended to indefinitely reinvest such earnings outside the United States. Whether we will ultimately take advantage of this provision depends on our review of the Act and any additional guidance provided and we are therefore currently uncertain as to the impact, if any, this matter will have on our consolidated financial statements, and are unable to estimate the amount of earnings we may repatriate.

Exposure Draft – Amendment of SFAS 140

The Financial Accounting Standards Board (FASB) intends to reissue the exposure draft, “Qualifying Special Purpose Entities and Isolation of Transferred Assets, an Amendment of FASB Statement No. 140,” during the third quarter of calendar year 2005. The purpose of the proposal is to provide more specific guidance on the accounting for transfers of financial assets to a QSPE.

-13-


 

     Provisions in the first exposure draft, as well as tentative decisions reached by the FASB during its deliberations, may require us to consolidate our current QSPEs (the Trusts) established in our Mortgage Services segment. As of January 31, 2005, the Trusts had both assets and liabilities of $5.3 billion. The provisions of the exposure draft are subject to FASB due process and are subject to change. We will continue to monitor the status of the exposure draft, and consider changes, if any, to current structures as a result of the proposed rules.

15. Condensed Consolidating Financial Statements

Block Financial Corporation (BFC) is an indirect, wholly owned consolidated subsidiary of the Company. BFC is the Issuer and the Company is the Guarantor of the Senior Notes issued on October 21, 1997, April 13, 2000 and October 26, 2004. These condensed consolidating financial statements have been prepared using the equity method of accounting. Earnings of subsidiaries are, therefore, reflected in the Company’s investment in subsidiaries account. The elimination entries eliminate investments in subsidiaries, related stockholder’s equity and other intercompany balances and transactions. The income statement for the three and nine months ended January 31, 2004 and statement of cash flows for the nine months ended January 31, 2004 and balance sheet as of April 30, 2004 have been adjusted to reflect intercompany royalties between BFC and other subsidiaries. These adjustments have no effect on H&R Block, Inc. (Guarantor) or Consolidated H&R Block.

Condensed Consolidating Income Statements

                                         
                              (in 000s)  
 
    Three months ended January 31, 2005  
    H&R Block, Inc.     BFC     Other             Consolidated  
    (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
Total revenues
  $     $ 442,279     $ 593,396     $ (3,668 )   $ 1,032,007  
 
                             
 
                                       
Cost of services
          104,532       404,641       (69 )     509,104  
Other
          218,724       175,827       (3,599 )     390,952  
 
                             
Total expenses
          323,256       580,468       (3,668 )     900,056  
 
                             
Operating income
          119,023       12,928             131,951  
Other income, net
    151,683       16,694       3,038       (151,683 )     19,732  
 
                             
Income before taxes
    151,683       135,717       15,966       (151,683 )     151,683  
Income taxes
    59,991       55,491       4,500       (59,991 )     59,991  
 
                             
Net income
  $ 91,692     $ 80,226     $ 11,466     $ (91,692 )   $ 91,692  
 
                             
                                         
    Three months ended January 31, 2004  
    H&R Block, Inc.     BFC     Other             Consolidated  
    (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
Total revenues
  $     $ 443,546     $ 523,660     $ (4,376 )   $ 962,830  
 
                             
 
                                       
Cost of services
          96,911       357,669       (238 )     454,342  
Other
          200,534       137,698       (4,248 )     333,984  
 
                             
Total expenses
          297,445       495,367       (4,486 )     788,326  
 
                             
Operating income
          146,101       28,293       110       174,504  
Other income, net
    176,120             1,616       (176,120 )     1,616  
 
                             
Income before taxes
    176,120       146,101       29,909       (176,010 )     176,120  
Income taxes
    69,394       59,261       10,089       (69,350 )     69,394  
 
                             
Net income
  $ 106,726     $ 86,840     $ 19,820     $ (106,660 )   $ 106,726  
 
                             

-14-


 

                                         
    Nine months ended January 31, 2005  
    H&R Block, Inc.     BFC     Other             Consolidated  
    (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
Total revenues
  $     $ 1,105,209     $ 959,051     $ (10,287 )   $ 2,053,973  
 
                             
 
                                       
Cost of services
          293,809       831,045       40       1,124,894  
Other
          573,196       396,265       (10,327 )     959,134  
 
                             
Total expenses
          867,005       1,227,310       (10,287 )     2,084,028  
 
                             
Operating income (loss)
          238,204       (268,259 )           (30,055 )
Other income, net
    (6,805 )     16,694       6,556       6,805       23,250  
 
                             
Income (loss) before taxes
    (6,805 )     254,898       (261,703 )     6,805       (6,805 )
Income taxes (benefit)
    (2,215 )     107,051       (109,266 )     2,215       (2,215 )
 
                             
Net income (loss)
  $ (4,590 )   $ 147,847     $ (152,437 )   $ 4,590     $ (4,590 )
 
                             
                                         
    Nine months ended January 31, 2004  
    H&R Block, Inc.     BFC     Other             Consolidated  
    (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
Total revenues
  $     $ 1,194,867     $ 841,811     $ (9,592 )   $ 2,027,086  
 
                             
 
                                       
Cost of services
          265,432       726,826       (671 )     991,587  
Other
          519,694       317,557       (9,360 )     827,891  
 
                             
Total expenses
          785,126       1,044,383       (10,031 )     1,819,478  
 
                             
Operating income (loss)
          409,741       (202,572 )     439       207,608  
Other income, net
    212,083             4,475       (212,083 )     4,475  
 
                             
Income (loss) before taxes
    212,083       409,741       (198,097 )     (211,644 )     212,083  
Income taxes (benefit)
    83,462       166,728       (83,439 )     (83,289 )     83,462  
 
                             
Net income (loss) before change in accounting
    128,621       243,013       (114,658 )     (128,355 )     128,621  
Cumulative effect of change in accounting
    (6,359 )           (6,359 )     6,359       (6,359 )
 
                             
Net income (loss)
  $ 122,262     $ 243,013     $ (121,017 )   $ (121,996 )   $ 122,262  
 
                             
     
 

Condensed Consolidating Balance Sheets

                                         
                              (in 000s)  
 
    January 31, 2005  
    H&R Block, Inc.     BFC     Other             Consolidated  
    (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
Cash & cash equivalents
  $     $ 138,602     $ 437,544     $     $ 576,146  
Cash & cash equivalents – restricted
          520,000       15,318             535,318  
Receivables from customers, brokers and dealers, net
          623,225                   623,225  
Receivables, net
    396       1,104,735       355,966             1,461,097  
Intangible assets and goodwill, net
          439,816       831,294             1,271,110  
Investments in subsidiaries
    4,335,074       210       428       (4,335,074 )     638  
Other assets
          1,196,549       476,989       49       1,673,587  
 
                             
Total assets
  $ 4,335,470     $ 4,023,137     $ 2,117,539     $ (4,335,025 )   $ 6,141,121  
 
                             
 
                                       
Commercial paper
  $     $ 1,508,784     $ 20,098     $     $ 1,528,882  
Accts. payable to customers, brokers and dealers
          1,035,228                   1,035,228  
Long-term debt
          896,382       32,147             928,529  
Other liabilities
    2       335,161       864,661       8       1,199,832  
Net intercompany advances
    2,886,818       (1,196,776 )     (1,690,083 )     41        
Stockholders’ equity
    1,448,650       1,444,358       2,890,716       (4,335,074 )     1,448,650  
 
                             
Total liabilities and stockholders’ equity
  $ 4,335,470     $ 4,023,137     $ 2,117,539     $ (4,335,025 )   $ 6,141,121  
 
                             

-15-


 

                                         
    April 30, 2004  
    H&R Block, Inc.     BFC     Other             Consolidated  
    (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
Cash & cash equivalents
  $     $ 132,076     $ 939,600     $     $ 1,071,676  
Cash & cash equivalents – restricted
          532,201       13,227             545,428  
Receivables from customers, brokers and dealers, net
          625,076                   625,076  
Receivables, net
    180       168,879       178,851             347,910  
Intangible assets and goodwill, net
          461,791       823,456             1,285,247  
Investments in subsidiaries
    4,291,693       205       297       (4,291,693 )     502  
Other assets
    (145 )     1,115,435       389,270       (373 )     1,504,187  
 
                             
Total assets
  $ 4,291,728     $ 3,035,663     $ 2,344,701     $ (4,292,066 )   $ 5,380,026  
 
                             
 
                                       
Accts. payable to customers, brokers and dealers
  $     $ 1,065,793     $     $     $ 1,065,793  
Long-term debt
          498,225       47,586             545,811  
Other liabilities
    15,879       509,151       1,345,822       561       1,871,413  
Net intercompany advances
    2,378,840       (304,432 )     (2,073,847 )     (561 )      
Stockholders’ equity
    1,897,009       1,266,926       3,025,140       (4,292,066 )     1,897,009  
 
                             
Total liabilities and stockholders’ equity
  $ 4,291,728     $ 3,035,663     $ 2,344,701     $ (4,292,066 )   $ 5,380,026  
 
                             
     
 

Condensed Consolidating Statements of Cash Flows

                                         
                              (in 000s)  
 
    Nine months ended January 31, 2005  
    H&R Block, Inc.     BFC     Other             Consolidated  
    (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
Net cash provided by (used in) operating activities:
  $ 16,683     $ (828,974 )   $ (772,960 )   $     $ (1,585,251 )
 
                             
Cash flows from investing:
                                       
Cash received on residuals
          100,344                   100,344  
Purchase property & equipment
          (26,355 )     (111,128 )           (137,483 )
Payments for business acquisitions
                (26,348 )           (26,348 )
Net intercompany advances
    499,699                   (499,699 )      
Other, net
          (150 )     15,357             15,207  
 
                             
Net cash provided by (used in) investing activities
    499,699       73,839       (122,119 )     (499,699 )     (48,280 )
 
                             
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  
Repayment of long-term debt
          (250,000 )                 (250,000 )
Proceeds from long-term debt
          395,221                   395,221  
Payments on acquisition debt
                (19,462 )           (19,462 )
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
          (892,344 )     392,645       499,699        
Other, net
                (258 )           (258 )
 
                             
Net cash provided by (used in) financing activities
    (516,382 )     761,661       393,023       499,699       1,138,001  
 
                             
Net increase (decrease) in cash
          6,526       (502,056 )           (495,530 )
Cash – beginning of period
          132,076       939,600             1,071,676  
 
                             
Cash – end of period
  $     $ 138,602     $ 437,544     $     $ 576,146  
 
                             

-16-


 

                                         
    Nine months ended January 31, 2004  
    H&R Block, Inc.     BFC     Other             Consolidated  
    (Guarantor)     (Issuer)     Subsidiaries     Elims     H&R Block  
Net cash provided by (used in) operating activities:
  $ 30,336     $ (635,888 )   $ (396,088 )   $     $ (1,001,640 )
 
                             
Cash flows from investing:
                                       
Cash received on residuals
          127,997                   127,997  
Purchase property & equipment
          (28,037 )     (53,141 )           (81,178 )
Payments for business acquisitions
                (280,280 )           (280,280 )
Net intercompany advances
    333,289                   (333,289 )      
Other, net
          40,474       (4,422 )           36,052  
 
                             
Net cash provided by (used in) investing activities
    333,289       140,434       (337,843 )     (333,289 )     (197,409 )
 
                             
Cash flows from financing:
                                       
Repayments of commercial paper
          (1,022,716 )                 (1,022,716 )
Proceeds from commercial paper
          2,433,893                   2,433,893  
Payments on acquisition debt
                (50,820 )           (50,820 )
Repayments of securitization financing
          (50,100 )                 (50,100 )
Proceeds from securitization financing
          50,100                   50,100  
Dividends paid
    (103,538 )                       (103,538 )
Acquisition of treasury shares
    (371,242 )                       (371,242 )
Proceeds from issuance of common stock
    111,155                         111,155  
Net intercompany advances
          (938,167 )     604,878       333,289        
Other, net
                (1,947 )           (1,947 )
 
                             
Net cash provided by (used in) financing activities
    (363,625 )     473,010       552,111       333,289       994,785  
 
                             
Net decrease in cash
          (22,444 )     (181,820 )           (204,264 )
Cash – beginning of period
          180,181       695,172             875,353  
 
                             
Cash – end of period
  $     $ 157,737     $ 513,352     $     $ 671,089  
 
                             
     
 

-17-


 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

     
 
RESULTS OF OPERATIONS
 

H&R Block is a diversified company delivering tax services and financial advice, investment and mortgage services, and business and consulting services. For nearly 50 years, we have been developing relationships with millions of tax clients and our strategy is to expand on these relationships. Our Tax Services segment provides income tax return preparation services, electronic filing services and other services and products related to income tax return preparation to the general public in the United States, Canada, Australia and the United Kingdom. We also offer investment services through H&R Block Financial Advisors, Inc. (HRBFA). Our Mortgage Services segment offers a full range of home mortgage services through Option One Mortgage Corporation (OOMC) and H&R Block Mortgage Corporation (HRBMC). RSM McGladrey Business Services, Inc. (RSM) is a national accounting, tax and consulting firm primarily serving mid-sized businesses.

Our Mission
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 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,  
 
    2005     2004     2005     2004  
 
Revenues:
                                     
Tax Services
  $ 531,086     $ 474,495     $ 655,639     $ 586,760  
Mortgage Services
    304,643       317,599       854,410       950,361  
Business Services
    132,872       112,293       371,021       319,816  
Investment Services
    62,104       57,753       169,446       167,443  
Corporate
    1,302       690       3,457       2,706  
 
                       
 
  $ 1,032,007     $ 962,830     $ 2,053,973     $ 2,027,086  
 
                       
Pretax income (loss):
                               
Tax Services
  $ 64,337     $ 61,827     $ (182,624 )   $ (168,136 )
Mortgage Services
    111,681       154,476       311,421       502,331  
Business Services
    5,936       1,955       (9,048 )     (7,456 )
Investment Services
    (18,312 )     (12,811 )     (61,149 )     (41,904 )
Corporate
    (11,959 )     (29,327 )     (65,405 )     (72,752 )
 
                       
 
    151,683       176,120       (6,805 )     212,083  
Income taxes (benefit)
    59,991       69,394       (2,215 )     83,462  
 
                       
Net income (loss) before change in accounting principle
    91,692       106,726       (4,590 )     128,621  
Cumulative effect of change in accounting principle
                      (6,359 )
 
                       
Net income (loss)
  $ 91,692     $ 106,726     $ (4,590 )   $ 122,262  
 
                       
 
                               
Basic earnings (loss) per share
  $ .56     $ .60     $ (.03 )   $ .69  
 
                       
Diluted earnings (loss) per share
  $ .55     $ .59     $ (.03 )   $ .67  
 
                       
     
 

OVERVIEW

A summary of our results compared to the prior year is as follows:

  •   Diluted earnings per share for the three months ended January 31, 2005 and 2004 was $0.55 and $0.59, respectively, and a loss of $0.03 and income of $0.67 for the respective nine-month periods. Results for the current quarter include a non-operating gain of $16.7 million, or $0.06 per diluted share, resulting from a legal recovery.

-18-


 

  •   Tax Services’ pretax income increased $2.5 million, to $64.3 million for the quarter. For the nine months, the pretax loss increased $14.5 million to $182.6 million, primarily due to real estate expansion, which resulted in the opening of a net 939 new company-owned office locations.
 
  •   Mortgage Services’ revenues and pretax income decreased $13.0 million and $42.8 million, respectively, for the three months ended January 31, 2005. Revenues and pretax income decreased $96.0 million and $190.9 million, for the respective nine-month periods. These declines are due to increased price competition and poorer execution in the secondary market, partially offset by increases in origination volumes of 56.8% and 27.7% for the three and nine months, respectively.
 
  •   Business Services’ revenues increased $20.6 million and $51.2 million for the three and nine months ended January 31, 2005, respectively, primarily due to higher chargeable hours in our accounting, tax and consulting business. Chargeable hours increased primarily as a result of risk management services and business development initiatives. Pretax income increased $4.0 million for the current quarter primarily due to revenue growth. For the nine months ended January 31, 2005, the pretax loss increased $1.6 million primarily due to increased personnel recruiting and compensation costs and investments made in our emerging businesses.
 
  •   Investment Services’ revenues increased $4.4 million and $2.0 million and the pretax loss increased $5.5 million and $19.2 million for the three and nine months, respectively. Declining results are primarily due to additional compensation and benefits from higher commission rates and financial incentives for new advisors coupled with increased legal expenses, partially offset by gains on the disposition of certain assets. In addition, a $6.0 million write-down of a branch office facility in the second quarter contributed to the increased loss during the nine months ended January 31, 2005.

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,  
 
    2005     2004  
 
Clients served (in 000s):
               
Company-owned offices
    2,447       2,362  
Franchise offices
    1,406       1,352  
Digital tax solutions (1)
    1,129       1,268  
 
           
 
    4,982       4,982  
 
           
Average fee per client served: (2)
               
Company-owned offices
  $ 149.94     $ 140.25  
Franchise offices
    130.82       125.61  
 
           
 
  $ 142.97     $ 134.92  
 
           
Refund anticipation loans (RALs) (in 000s):
               
Company-owned offices
    1,197       1,184  
Franchise offices
    714       709  
Digital tax solutions
    12       20  
 
           
 
    1,923       1,913  
 
           
Offices:
               
Company-owned offices
    5,811       5,172  
Company-owned shared office locations (3)
    1,296       996  
 
           
Total company-owned offices
    7,107       6,168  
 
           
 
Franchise offices
    3,528       3,418  
Franchise shared office locations (3)
    526       323  
 
           
Total franchise offices
    4,054       3,741  
 
           
 
    11,161       9,909  
 
           
     
 
    (1) Includes online completed and paid returns and federal software units sold.
    (2) Calculated as tax preparation and related fees divided by clients served.
    (3) Shared locations include offices located within Wal-Mart, Sears and other third-party businesses.

 

-19-


 

                                 
 
Tax Services – Operating Results                                    (in 000s)  
 
    Three months ended January 31,     Nine months ended January 31,  
 
    2005     2004     2005     2004  
 
Service revenues:
                               
Tax preparation and related fees
  $ 375,343     $ 339,204     $ 428,322     $ 383,993  
Online tax services
    10,740       8,200       12,048       9,171  
Other services
    23,885       15,812       77,025       64,771  
 
                       
 
    409,968       363,216       517,395       457,935  
Royalties
    50,920       44,427       56,271       49,410  
RAL participation fees
    43,354       37,185       43,520       37,192  
RAL waiver fees
          988             6,548  
Software sales
    17,812       18,915       20,437       19,733  
Other
    9,032       9,764       18,016       15,942  
 
                       
Total revenues
    531,086       474,495       655,639       586,760  
 
                       
 
                               
Cost of services:
                               
Compensation and benefits
    179,187       160,001       253,108       226,240  
Occupancy
    74,270       66,142       177,779       158,444  
Depreciation
    14,907       12,924       33,522       31,021  
Supplies
    12,701       11,410       20,716       17,897  
Other
    47,484       42,872       106,860       101,808  
 
                       
 
    328,549       293,349       591,985       535,410  
Cost of software sales
    12,731       13,231       20,400       19,939  
Selling, general and administrative
    125,469       106,088       225,878       199,547  
 
                       
Total expenses
    466,749       412,668       838,263       754,896  
 
                       
Pretax income (loss)
  $ 64,337     $ 61,827     $ (182,624 )   $ (168,136 )
 
                       
     
 

Three months ended January 31, 2005 compared to January 31, 2004

Tax Services’ revenues increased $56.6 million, or 11.9%, for the three months ended January 31, 2005 compared to the prior year.

     Tax preparation and related fees increased $36.1 million, or 10.7%, for the current quarter. This increase is primarily due to an increase in the average fee per U.S. client served, coupled with an increase in U.S. clients served in offices. The average fee per client served increased 6.9% to $149.94 in the current year compared to $140.25 last year. Clients served in company-owned offices during the current tax season totaled 2.4 million, up 3.6% from the prior year. We estimate that approximately $10.8 million of the total increase is due to new offices opened during the current year.

     Other service revenues increased $8.1 million primarily as a result of additional revenues associated with Refund Anticipation Checks (RACs), Express IRAs and, to a lesser extent, increased revenues from POM guarantees.

     The average fee per client served at franchise offices increased by 4.1%, while clients served rose 4.0%. These increases, coupled with a slight increase in the royalty rate during the current quarter, resulted in a $6.5 million increase in royalty revenue.

     Revenues earned during the current quarter in connection with RAL participations totaled $43.4 million, an increase of 16.6% over the prior year. This increase is primarily due to an increase in the dollar value of loans in which we purchased participation interests, resulting from an increase in the fee charged by the lender, an increase in our clients’ average refund size, and an increase in the maximum loan amount allowed by the lender.

     Cost of services for the three months ended January 31, 2005 increased $35.2 million, or 12.0%, from the prior year. Our real estate expansion efforts have contributed to increases across all cost of services categories and resulted in a net 639 new stand-alone company-owned offices and a net 300 new company-owned shared-office locations. Compensation and benefits increased $19.2 million primarily due to an increase in the number of tax professionals and support staff needed for our new offices, the increase in revenues and higher payroll tax rates. Occupancy expenses increased $8.1 million, or 12.3%, primarily as a result of higher rent expenses, due to an 11.3% increase in company-owned offices under lease and a 2.7% increase in the average rent. Utilities related to these new offices also contributed to the increase. Other cost of service expenses increased $4.6 million primarily due to additional expenses associated with our POM program.

-20-


 

     Selling, general and administrative expenses increased $19.4 million over the prior year primarily due to increased spending on marketing initiatives and a $5.1 million increase in legal expenses. Legal expenses increased partially due to reserves required for RAL-related litigation.

     Pretax income of $64.3 million for the three months ended January 31, 2005 represents a 4.1% increase over prior year income of $61.8 million.

     Due to the seasonal nature of this segment’s business, operating results for the three months ended January 31, 2005 are not comparable to the three months ended October 31, 2004 and are not indicative of the expected results for the entire fiscal year.

Nine months ended January 31, 2005 compared to January 31, 2004

Tax Services’ revenues increased $68.9 million, or 11.7%, for the nine months ended January 31, 2005 compared to the prior year.

     Tax preparation and related fees increased $44.3 million, or 11.5%, for the nine months ended January 31, 2005. This increase is primarily due to an increase in the average fee per client served, coupled with an increase in U.S. clients served in offices during the first month of the tax season. Australian tax returns prepared increased 5.2% and the average charge increased 2.8%, resulting in $3.6 million of additional revenues.

     Other service revenues increased $12.3 million primarily as a result of additional revenues associated with POM guarantees and, to a lesser extent, increased revenues from RACs and Express IRAs.

     The average fee per client served and clients served both increased at our franchise offices, resulting in an increase in royalty revenue of 13.9%.

     Revenues earned during the current year in connection with RAL participations totaled $43.5 million, an increase of 17.0% over the prior year. This increase is primarily due to an increase in the dollar amount of loans in which we purchased participation interests, resulting from an increase in the fee charged by the lender, an increase in our clients’ average refund size and the maximum loan amount allowed by the lender. This increase was offset by the elimination of RAL waiver revenue in the prior year associated with the RAL waiver agreement.

     Cost of services for the nine months ended January 31, 2005 were up $56.6 million, or 10.6%, from the prior year. Compensation and benefits increased $26.9 million primarily due to an increase in the number of tax professionals and support staff needed for our real estate expansion and increased revenues. Occupancy expenses increased $19.3 million, or 12.2%, as a result of an 11.3% increase in company-owned offices under lease. Other cost of service expenses increased $5.1 million primarily due to additional expenses associated with Express IRAs.

     Selling, general and administrative expenses increased $26.3 million over the prior year due to increased spending related to additional marketing efforts, legal expenses and information technology expenses.

     The pretax loss of $182.6 million for the nine months ended January 31, 2005 represents an 8.6% increase over the prior year loss of $168.1 million.

Fiscal 2005 outlook

Our fiscal year 2005 outlook for the Tax Services segment is unchanged from the discussion in our April 30, 2004 Form 10-K and our October 31, 2004 Form 10-Q. Clients served across our retail network through February 15, 2005 were up 4.0% and we believe we are on track to meet our expectations for the year. However, results in interim periods may not necessarily be representative of the overall results for the season.

RAL Litigation

We have been named as a defendant in a number of lawsuits alleging that we engaged in wrongdoing with respect to the RAL program. We believe we have strong defenses to the various RAL cases and will vigorously defend our position. Nevertheless, the amounts claimed by the plaintiffs are, in some instances, very substantial, and there can be no assurances as to the ultimate outcome of the pending RAL cases, or as to the impact of the RAL cases on our financial statements. See additional discussion of RAL Litigation in note 12 to the condensed consolidated financial statements and in Part II, Item 1, “Legal Proceedings.”

-21-


 

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.

                         
 
Mortgage Services – Operating Statistics           (dollars in 000s)  
 
Three months ended   January 31, 2005     January 31, 2004     October 31, 2004  
 
Volume of loans originated:
                       
Wholesale (non-prime)
  $ 7,378,071     $ 4,732,182     $ 5,528,361  
Retail:Prime
    238,867       157,438       183,647  
Non-prime
    776,797       464,926       800,975  
 
                 
 
  $ 8,393,735     $ 5,354,546     $ 6,512,983  
 
                 
Loan characteristics:
                       
Weighted average FICO score (1)
    615       607       609  
Weighted average interest rate for borrowers (1)
    7.30 %     7.47 %     7.46 %
Weighted average loan-to-value (1)
    79.3 %     78.1 %     78.3 %
 
Revenue (loan value):
                       
Net gain on sale – gross margin (2)
    2.42 %     3.93 %     2.83 %
 
Loan delivery:
                       
Loan sales
  $ 8,348,537     $ 5,308,800     $ 6,560,780  
Execution price (3)
    2.82 %     4.08 %     2.94 %
     
 
    (1) Represents non-prime production.
   
(2) 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.
   
(3) 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).

 

-22-


 

                         
   
Mortgage Services - Operating Results (in 000s)  
Three months ended   January 31, 2005     January 31, 2004     October 31, 2004  
 
Components of gains on sales:
                       
Gain on mortgage loans
  $ 172,381     $ 217,915     $ 187,195  
Gain (loss) on derivatives
    30,756       (7,724 )     (2,606 )
Gain on sales of residual interests
          17,000        
Impairment of residual interests
    (4,835 )     (14,942 )     (34 )
 
                 
 
    198,302       212,249       184,555  
 
                 
Interest income:
                       
Accretion - residual interests
    28,782       47,483       32,172  
Other interest income
    4,064       2,227       2,445  
 
                 
 
    32,846       49,710       34,617  
 
                 
Loan servicing revenue
    72,928       55,072       61,907  
Other
    567       568       555  
 
                 
Total revenues
    304,643       317,599       281,634  
 
                 
                           
Cost of services
    56,694       52,832       53,062  
Compensation and benefits
    80,185       62,874       68,945  
Occupancy
    11,519       9,059       11,327  
Other
    44,564       38,358       42,100  
 
                 
Total expenses
    192,962       163,123       175,434  
 
                 
Pretax income
  $ 111,681     $ 154,476     $ 106,200  
 
                 
 

Three months ended January 31, 2005 compared to January 31, 2004

Mortgage Services’ revenues decreased $13.0 million, or 4.1%, for the three months ended January 31, 2005 compared to the prior year. Revenues decreased as a result of a decline in gains on sales of mortgage loans and residual interests and lower accretion income, somewhat offset by gains on derivatives and increased servicing revenue.

     The following table summarizes the key drivers of gains on sales of mortgage loans:

                 
(dollars in 000s)
Three months ended January 31,   2005     2004  
 
Application process:
               
Total number of applications
    84,810       59,328  
Number of sales associates (1)
    3,523       2,649  
Closing ratio (2)
    60.4 %     60.3 %
Originations:
               
Total number of originations
    51,267       35,795  
Weighted average interest rate for borrowers (WAC)
    7.30 %     7.47 %
Average loan size
  $ 164     $ 150  
Total originations
  $ 8,393,735     $ 5,354,546  
Non-prime origination ratio
    97.2 %     97.1 %
Direct origination and acquisition expenses, net
  $ 110,432     $ 75,257  
Revenue (loan value):
               
Net gain on sale - gross margin (3)
    2.42 %     3.93 %
 
(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.

     Although we continue to grow our origination volumes, up 56.8% over the prior year, gains on sales of mortgage loans declined $45.5 million, primarily as a result of increased price competition and poorer execution in the secondary market. Market interest rates, based on a two-year swap, increased from 2.20% last year to 3.64% at the end of the current quarter. However, our WAC declined to 7.30% from 7.47% in the prior year. Because our WAC was not more aligned with market rates, our gross margin declined 151 basis points, to 2.42% from 3.93% last year. To mitigate the risk of short-term changes in market interest rates, we use interest rate swaps and forward loan sale commitments. During the current

-23-


 

quarter, we recorded a net $30.8 million in gains, compared to losses of $7.7 million in the prior year, related to our various derivative instruments. See note 6 to the condensed consolidated financial statements.

     During the current year, we reclassified the accretion on our beneficial interest in Trusts, which includes actual cash received from the Trusts in excess of those estimated, from interest income to gain on sale. This change was made to more accurately reflect the characteristics of the proceeds received by the beneficial interest holders upon disposition of the loans by the Trusts. Amounts reclassified from interest income to gains on sales for the three months ended January 31, 2004 totaled $57.6 million. This change had no impact on our net income as previously reported.

     In the prior year we recorded $17.0 million in gains on sales of previously securitized residual interests, while no similar transaction occurred in the current year.

     Impairments of residual interests in securitizations of $4.8 million were recognized during the current quarter, compared with $14.9 million in the prior year.

     The following table summarizes the key drivers of loan servicing revenues:

                 
            (dollars in 000s)  
 
Three months ended January 31,   2005     2004  
 
Average servicing portfolio:
               
With related MSRs
  $ 41,753,865     $ 33,427,112  
Without related MSRs
    15,584,677       7,797,396  
 
           
 
  $ 57,338,542     $ 41,224,508  
 
           
 
Number of loans serviced
    387,619       308,305  
Average delinquency rate
    5.02 %     6.00 %
Value of MSRs
  $ 147,511     $ 106,196  
 

     Loan servicing revenues increased $17.9 million, or 32.4%, compared to the prior year. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the three months ended January 31, 2005 increased $16.1 billion, or 39.1%, to $57.3 billion.

     Accretion of residual interests of $28.8 million for the three months ended January 31, 2005 represents a decrease of $18.7 million from the prior year. This decrease is primarily due to the sale of previously securitized residual interests during fiscal year 2004, which eliminated future accretion on those residual interests.

     During the third quarter of fiscal year 2005, our residual interests continued to perform better than expected compared to internal valuation models, primarily due to credit losses performing better than originally modeled. We recorded favorable pretax mark-to-market adjustments, which increased the fair value of our residual interests $18.8 million during the quarter. These adjustments were recorded, net of write-downs of $9.0 million and deferred taxes of $3.8 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests. Future changes in interest rates or other assumptions, based on market conditions or actual loan pool performance, could cause additional adjustments to the fair value of the residual interests and could cause changes to the accretion of these residual interests in future periods. Favorable mark-to-market adjustments on low original value residuals will generally not be accreted into revenues until the residual interest begins to cash flow.

     Total expenses for the three months ended January 31, 2005, increased $29.8 million, or 18.3%, over the year-ago quarter. This increase is primarily due to $17.3 million in increased compensation and benefits as a result of a 33.0% increase in sales associates, coupled with related increases in payroll taxes and origination-based incentives. Other expenses increased $6.2 million for the current quarter, primarily due to a $1.5 million increase in consulting expenses, and similar increases in depreciation and travel. Costs related to servicing of mortgage loans increased $3.9 million as a result of a higher average servicing portfolio during the three months ended January 31, 2005.

     Pretax income decreased $42.8 million to $111.7 million for the three months ended January 31, 2005.

-24-


 

Three months ended January 31, 2005 compared to October 31, 2004

Mortgage Services’ revenues increased $23.0 million, or 8.2%, for the three months ended January 31, 2005, compared to the second quarter. Revenues increased due to gains on derivatives and higher servicing revenues, partially offset by lower gains on sales of mortgage loans.

     The following table summarizes the key drivers of gains on sales of mortgage loans:

                 
            (dollars in 000s)  
 
Three months ended   January 31, 2005     October 31, 2004  
 
Application process:
               
Total number of applications
    84,810       72,699  
Number of sales associates (1)
    3,523       3,369  
Closing ratio (2)
    60.4 %     57.0 %
Originations:
               
Total number of originations
    51,267       41,422  
Weighted average interest rate for borrowers (WAC)
    7.30 %     7.46 %
Average loan size
  $ 164     $ 157  
Total originations
  $ 8,393,735     $ 6,512,983  
Non-prime origination ratio
    97.2 %     97.2 %
Direct origination and acquisition expenses, net
  $ 110,432     $ 86,239  
Revenue (loan value):
               
Net gain on sale - gross margin (3)
    2.42 %     2.83 %
 
(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 $14.8 million primarily as a result of increased price competition and poorer execution in the secondary market. Market interest rates have increased to 3.64% from 2.94% in the second quarter. However our WAC declined from 7.46% to 7.30%. Because our WAC was not more aligned with market rates, our gross margin declined 41 basis points. To mitigate the risk of short-term changes in market interest rates, we use interest rate swaps and forward loan sale commitments. During the current quarter, we recorded a net $30.8 million in gains, compared to a net loss of $2.6 million in the second quarter, related to our various derivative instruments. Loan origination volumes increased 28.9% from the second quarter primarily due to the hiring of additional sales associates.

     Impairments of residual interests in securitizations of $4.8 million were recognized during the third quarter.

     The following table summarizes the key drivers of loan servicing revenues:

                 
            (dollars in 000s)  
 
Three months ended   January 31, 2005     October 31, 2004  
 
Average servicing portfolio:
               
With related MSRs
  $ 41,753,865     $ 39,407,600  
Without related MSRs
    15,584,677       11,917,124  
 
           
 
  $ 57,338,542     $ 51,324,724  
 
           
 
Number of loans serviced
    387,619       362,430  
Average delinquency rate
    5.02 %     5.19 %
Value of MSRs
  $ 147,511     $ 134,062  
 

     Loan servicing revenues increased $11.0 million, or 17.8%, compared to the second quarter. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the three months ended January 31, 2005 increased $6.0 billion, or 11.7%.

     Total expenses increased $17.5 million compared to the second quarter. This increase is primarily due to $11.2 million in increased compensation and benefits as a result of a 4.6% increase in sales associates, coupled with related increases in payroll taxes and origination-based incentives. Other expenses increased $2.5 million for the current quarter, primarily due to a $5.6 million increase in marketing costs, which was partially offset by a $3.2 million decrease in consulting expenses. Costs related to servicing of mortgage loans increased $3.6 million as a result of a higher average servicing portfolio.

-25-


 

     Pretax income increased $5.5 million, or 5.2%, for the three months ended January 31, 2005 compared to the preceding quarter.

                 
 
Mortgage Services – Operating Statistics (dollars in 000s)
Nine months ended January 31,   2005     2004  
 
Volume of loans originated:
               
Wholesale (non-prime)
  $ 18,887,536     $ 14,740,523  
Retail:Prime
    637,801       945,424  
Non-prime
    2,197,898       1,323,236  
 
           
 
  $ 21,723,235     $ 17,009,183  
 
           
Loan characteristics:
               
Weighted average FICO score (1)
    611       608  
Weighted average interest rate for borrowers (1)
    7.32 %     7.51 %
Weighted average loan-to-value (1)
    78.6 %     78.2 %
       
Revenue (loan value):
               
Net gain on sale – gross margin (2)
    2.64 %     4.01 %
       
Loan delivery:
               
Loan sales
  $ 21,653,373     $ 16,940,590  
Execution price (3)
    3.21 %     4.14 %
 
(1)     Represents non-prime production.
(2)     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.
(6)     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).


-26-


 

                 
   
Mortgage Services - Operating Results (in 000s)
Nine months ended January 31,   2005     2004  
 
Components of gains on sales:
               
Gain on mortgage loans
  $ 544,428     $ 685,549  
Gain (loss) on derivatives
    28,826       (4,297 )
Gain on sales of residual interests
          17,000  
Impairment of residual interests
    (8,304 )     (26,048 )
 
           
 
    564,950       672,204  
 
           
Interest income:
               
Accretion - residual interests
    86,618       118,389  
Other interest income
    7,947       3,043  
 
           
 
    94,565       121,432  
 
           
Loan servicing revenue
    193,690       155,048  
Other
    1,205       1,677  
 
           
Total revenues
    854,410       950,361  
 
           
 
Cost of services
    161,869       144,020  
Compensation and benefits
    225,287       178,956  
Occupancy
    32,810       27,906  
Other
    123,023       97,148  
 
           
Total expenses
    542,989       448,030  
 
           
Pretax income
  $ 311,421     $ 502,331  
 
           
 

Nine months ended January 31, 2005 compared to January 31, 2004
Mortgage Services’ revenues decreased $96.0 million, or 10.1%, for the nine months ended January 31, 2005 compared to the prior year. Revenues decreased primarily as a result of a decline in gains on sales of mortgage loans.

        The following table summarizes the key drivers of gains on sales of mortgage loans:

                 
            (dollars in 000s)
 
Nine months ended January 31,   2005     2004  
 
Application process:
               
Total number of applications
    232,001       194,730  
Number of sales associates (1)
    3,523       2,649  
Closing ratio (2)
    58.9 %     58.3 %
Originations:
               
Total number of originations
    136,615       113,585  
Weighted average interest rate for borrowers (WAC)
    7.32 %     7.51 %
Average loan size
  $ 159     $ 150  
Total originations
  $ 21,723,235     $ 17,009,183  
Non-prime origination ratio
    97.1 %     94.4 %
Direct origination expenses, net
  $ 299,549     $ 208,315  
Revenue (loan value):
               
Net gain on sale – gross margin (3)
    2.64 %     4.01 %
 
(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.

     Although we continue to grow our origination volumes, up 27.7% over the prior year, gains on sales of mortgage loans declined $141.1 million as a result of increased price competition and poorer execution in the secondary market. Market interest rates have increased to 3.64% from 1.88% in early April and our WAC increased from 7.06% at April 30, 2004 to 7.32% at January 31, 2005. Because our WAC was not more aligned with market rates, our gross margin declined 137 basis points from last year. To mitigate the risk of short-term changes in market interest rates, we use interest rate swaps and forward loan sale commitments. During the current year, we recorded a net $28.8 million in gains, compared to a net loss of $4.3 million in the prior year, related to our various derivative instruments.

-27-


 

     As discussed previously, we reclassified accretion on our beneficial interest in Trusts from interest income to gain on sale. Amounts reclassified for the nine months ended January 31, 2004 totaled $125.9 million. This change had no impact on our net income as previously reported.

     In the prior year we recorded $17.0 million in gains on sales of previously securitized residual interests, while no similar transaction occurred in the current year.

     Impairments of residual interests in securitizations of $8.3 million were recognized in the current period, compared to $26.0 million for the nine months ended January 31, 2004.

     The following table summarizes the key drivers of loan servicing revenues:

                 
(dollars in 000s)
Nine months ended January 31,   2005     2004  
 
Average servicing portfolio:
               
With related MSRs
  $ 39,593,946     $ 30,931,506  
Without related MSRs
    12,586,192       5,975,852  
 
           
 
  $ 52,180,138     $ 36,907,358  
 
           
 
Number of loans serviced
    387,619       308,305  
Average delinquency rate
    5.03 %     6.27 %
Value of MSRs
  $ 147,511     $ 106,196  
 

     Loan servicing revenues increased $38.6 million, or 24.9%, compared to the prior year. The increase reflects a higher loan-servicing portfolio. The average servicing portfolio for the nine months ended January 31, 2005 increased $15.3 billion, or 41.4%.

     Accretion of residual interests of $86.6 million for the nine months ended January 31, 2005 represents a decrease of $31.8 million from the prior year. This decrease is primarily due to the sale of previously securitized residual interests during fiscal year 2004, which eliminated future accretion on those residual interests.

     During the first nine months of fiscal year 2005, our residual interests continued to perform better than expected compared to internal valuation models. We recorded favorable pretax mark-to-market adjustments, which increased the fair value of our residual interests $132.3 million during the year. These adjustments were recorded, net of write-downs of $33.6 million and deferred taxes of $37.7 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests.

     Total expenses for the nine months ended January 31, 2005, increased $95.0 million, or 21.2%, over the prior year. This increase is primarily due to $46.3 million in increased compensation and benefits as a result of a 33.0% increase in sales associates, reflecting the overall growth in operations. Other expenses increased $25.9 million for the current period, primarily due to an $8.9 million increase in consulting expenses, and increases in depreciation and travel expenses. Costs related to servicing of mortgage loans increased $17.8 million as a result of a higher average servicing portfolio.

     Pretax income decreased $190.9 million to $311.4 million for the nine months ended January 31, 2005.

Fiscal 2005 outlook
Due to continued pressure on our margins, our Mortgage Services segment fiscal year 2005 outlook has declined from the discussion in our April 30, 2004 Form 10-K. Based on these assumptions, we expect our mortgage segment pretax income to decline approximately 30% from fiscal year 2004, excluding the gain on sale of previously securitized residual interests. Beginning late in our fourth quarter and then more meaningfully in fiscal year 2006, we expect to realize a 50 to 75 basis point improvement in our total cost of origination, including the effect of potentially higher origination volumes.

-28-


 

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,
    2005     2004     2005     2004  
 
Accounting, tax and consulting:
                               
Chargeable hours
    641,009       580,746       1,852,346       1,682,073  
Chargeable hours per person
    332       322       935       904  
Net collected rate per hour
  $ 134     $ 126     $ 129     $ 122  
Average margin per person
  $ 25,194     $ 23,117     $ 64,621     $ 59,126  
 
                                 
   
Business Services – Operating Results (in 000s)
  Three months ended January 31, Nine months ended January 31,
    2005     2004     2005     2004  
 
Service revenues:
                               
Accounting, tax and consulting
  $ 90,880     $ 74,680     $ 259,207     $ 214,544  
Capital markets
    17,631       19,287       48,309       53,789  
Payroll, benefits and retirement services
    6,748       5,527       16,280       14,977  
Other services
    7,809       4,754       20,212       13,681  
 
                       
 
    123,068       104,248       344,008       296,991  
Other
    9,804       8,045       27,013       22,825  
 
                       
Total revenues
    132,872       112,293       371,021       319,816  
 
                       
 
Cost of services:
                               
Compensation and benefits
    68,730       56,707       206,631       165,306  
Occupancy
    6,572       4,935       17,111       15,393  
Other
    8,129       8,386       31,151       24,143  
 
                       
 
    83,431       70,028       254,893       204,842  
Selling, general and administrative
    43,505       40,310       125,176       122,430  
 
                       
Total expenses
    126,936       110,338       380,069       327,272  
 
                       
Pretax income (loss)
  $ 5,936     $ 1,955     $ (9,048 )   $ (7,456 )
 
                       
 

Three months ended January 31, 2005 compared to January 31, 2004
Business Services’ revenues for the three months ended January 31, 2005 increased $20.6 million, or 18.3%, from the prior year. This increase was primarily due to a $16.2 million increase in accounting, tax and consulting revenues resulting from a 6.3% increase in the net collected rate per hour and a 10.4% increase in chargeable hours. The increase in chargeable hours is primarily due to favorable market conditions for all of our core services and strong demand for consulting and risk management services. Other service revenues increased $3.1 million as a result of growth in our financial process outsourcing business and wealth management services. Capital markets revenues declined $1.7 million as a result of an 11.5% decrease in the number of business valuation projects. Other revenues increased $1.8 million as a result of increases in computer hardware and software sales to clients.

     Total expenses increased $16.6 million, or 15.0%, for the three months ended January 31, 2005 compared to the prior year. Compensation and benefits increased $12.0 million, primarily as a result of increases in the average wage per employee, which is being driven by marketplace competition for professional staff, and in the number of personnel. Selling, general and administrative expenses increased $3.2 million primarily due to increased personnel recruiting expenses and additional costs associated with our business development initiatives. Higher expenses are also attributable to investments we are making in early-stage businesses within this segment.

     Pretax income for the three months ended January 31, 2005 was $5.9 million compared to $2.0 million in the prior year.

-29-


 

     Due to the seasonal nature of this segment’s business, operating results for the three months ended January 31, 2005 are not comparable to the three months ended October 31, 2004 and are not indicative of the expected results for the entire fiscal year.

Nine months ended January 31, 2005 compared to January 31, 2004
Business Services’ revenues for the nine months ended January 31, 2005 increased $51.2 million, or 16.0%, from the prior year. This increase was primarily due to a $44.7 million increase in accounting, tax and consulting revenues resulting from a 5.7% increase in the net collected rate per hour and a 10.1% increase in chargeable hours. Additionally, reimbursable expenses and contractor revenues contributed $2.3 million and $3.8 million, respectively, to this increase. Other service revenues increased $6.5 million due to our wealth management services and the acquisition of our financial process outsourcing business in the second quarter of last year, coupled with baseline growth in this business. Capital markets revenues declined $5.5 million as a result of a 13.0% decrease in the number of business valuation projects. Other revenues increased $4.2 million as a result of increases in network product fees and computer hardware and software sales to clients.

     Total expenses increased $52.8 million, or 16.1%, for the nine months ended January 31, 2005 compared to the prior year. Compensation and benefits increased $41.3 million, primarily as a result of increases in the average wage per employee, which is being driven by marketplace competition for professional staff, and the number of personnel. Other cost of services increased as a result of higher reimbursable expenses billed to clients and contractor fees. Selling, general and administrative expenses increased $2.7 million primarily due to increased personnel recruiting expenses and additional costs associated with our strategic growth initiatives. Higher expenses are also attributable to investments we are making in early-stage businesses within this segment.

     The pretax loss for the nine months ended January 31, 2005 was $9.0 million compared to $7.5 million in the prior year.

Fiscal 2005 outlook
Our fiscal year 2005 outlook for our Business Services segment is unchanged from the discussion in our April 30, 2004 Form 10-K and our October 31, 2004 Form 10-Q.

INVESTMENT SERVICES
This segment is primarily engaged in offering advice-based brokerage services and investment planning. Our integration of investment advice and new service offerings are allowing us to shift our focus from a transaction-based client relationship to a more advice-based focus.

-30-


 

                         
   
Investment Servic – Operating Statistics
Three months ended   January 31, 2005     January 31, 2004     October 31, 2004  
 
Customer trades (1)
    245,612       272,003       192,909  
Customer daily average trades
    3,899       4,459       3,014  
Average revenue per trade (2)
  $ 120.62     $ 113.61     $ 125.13  
Customer accounts: (3)
                       
Traditional brokerage
    431,902       467,710       444,770  
Express IRAs
    295,676       241,116       334,928  
 
                 
 
    727,578       708,826       779,698  
 
                 
 
Ending balance of assets under administration (billions)
  $ 28.4     $ 27.5     $ 27.2  
Average assets per traditional brokerage account
  $ 65,339     $ 58,256     $ 60,225  
Average margin balances (millions)
  $ 596     $ 568     $ 590  
Average customer payable balances (millions)
  $ 989     $ 1,028     $ 962  
Number of advisors
    1,013       960       982  
 
Included in the numbers above are the following relating to fee-based accounts:        
Customer household accounts
    7,263       5,705       7,046  
Average revenue per account
  $ 2,149     $ 2,021     $ 2,044  
Ending balance of assets under administration (millions)
  $ 1,911     $ 1,342     $ 1,755  
Average assets per active account
  $ 248,400     $ 235,232     $ 249,068  
 
(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.
                         
   
Investment Services – Operating Results (in 000s)
Three months ended   January 31, 2005     January 31, 2004     October 31, 2004  
 
Service revenue:
                       
Transactional revenue
  $ 24,654     $ 26,504     $ 19,988  
Annuitized revenue
    18,382       15,324       17,199  
 
                 
Production revenue
    43,036       41,828       37,187  
Other service revenue
    7,000       8,568       6,527  
 
                 
 
    50,036       50,396       43,714  
 
                 
Margin interest revenue
    11,975       8,362       10,038  
Less: interest expense
    (1,090 )     (248 )     (541 )
 
                 
Net interest revenue
    10,885       8,114       9,497  
 
                 
Other
    93       (1,005 )     9  
 
                 
Total revenues (1)
    61,014       57,505       53,220  
 
                 
 
Cost of services:
                       
Compensation and benefits
    28,986       27,031       27,074  
Occupancy
    5,913       5,123       4,753  
Depreciation
    1,052       1,978       1,089  
Other
    4,478       4,001       3,447  
 
                 
 
    40,429       38,133       36,363  
Selling, general and administrative
    38,897       32,183       41,423  
 
                 
Total expenses
    79,326       70,316       77,786  
 
                 
Pretax loss
  $ (18,312 )   $ (12,811 )   $ (24,566 )
 
                 
 
(1) Total revenues, less interest expense.

Three months ended January 31, 2005 compared to January 31, 2004
Investment Services’ revenues, net of interest expense, for the three months ended January 31, 2005 increased $3.5 million, or 6.1%.

-31-


 

     Production revenue increased $1.2 million, or 2.9%, over the prior year. Transactional revenue, which is based on individual securities transactions, decreased $1.9 million, or 7.0%, from the prior year due primarily to a 15.8% decline in transactional trading volume. This decline was partially offset by an increase in average revenue per trade. Annuitized revenue, which is based on sales of mutual funds, insurance, fee based products and unit investment trusts, increased $3.1 million, or 20.0%, due to increased sales of annuities and mutual funds. Annualized productivity averaged approximately $172,000 per advisor during the current quarter compared to $185,000 per advisor in the prior year. Declining productivity was primarily due to advisor attrition.

     Margin interest revenue increased $3.6 million, or 43.2%, from the prior year, as a result of a 4.9% increase in average margin balances and higher interest rates earned.

     Cost of services increased $2.3 million, or 6.0%, primarily as a result of $2.0 million of additional compensation and benefits. This increase is primarily due to higher commission rates than the prior year and financial incentives for new advisors.

     Selling, general and administrative expenses increased $6.7 million, or 20.9%, over the prior year primarily as the result of gains of $2.2 million on the disposition of certain assets in the prior year, an increase of $2.1 million in legal expenses and $1.8 million in additional stock-based compensation.

     The pretax loss for Investment Services for the third quarter of fiscal year 2005 was $18.3 million compared to the prior year loss of $12.8 million.

Three months ended January 31, 2005 compared to October 31, 2004
Investment Services’ revenues, net of interest expense, for the three months ended January 31, 2005 increased $7.8 million, or 14.6% compared to the preceding quarter.

     Production revenue increased $5.8 million, or 15.7%, over the second quarter. Transactional revenue increased $4.7 million, or 23.3%, compared to the preceding quarter, primarily due to a 31.1% increase in transactional trading volume partially offset by a decline in average revenue per trade. Annuitized revenues rose $1.2 million, or 6.9%, due to increased mutual fund sales and trailer revenue. A total of 86 new advisors were recruited during the quarter. Our total advisor count increased from 982 to 1,013 during the period as a result of our recruiting efforts and declining advisor attrition.

     Margin interest revenue increased $1.9 million, or 19.3%, from the preceding quarter, which is primarily a result of higher interest rates earned.

     Cost of services increased $4.1 million, or 11.2%, principally due to a $1.9 million rise in compensation and benefits, primarily resulting from higher production revenues.

     Selling, general and administrative expenses decreased $2.5 million, or 6.1%, primarily due to a $6.0 million write-down of a branch office facility during the second quarter, partially offset by gains on the disposition of certain assets during the second quarter and $1.5 million in additional stock-based compensation recorded in the current quarter.

     The pretax loss for the Investment Services segment was $18.3 million, compared to a loss of $24.6 million in the second quarter.

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Investment Services – Operating Statistics
Nine months ended January 31,   2005     2004  
 
Customer trades (1)
    644,469       744,765  
Customer daily average trades
    3,410       3,859  
Average revenue per trade (2)
  $ 121.68     $ 118.74  
Customer accounts: (3)
               
Traditional brokerage
    431,902       467,710  
Express IRAs
    295,676       241,116  
 
           
 
    727,578       708,826  
 
           
 
Ending balance of assets under administration (billions)
  $ 28.4     $ 27.5  
Average assets per traditional brokerage account
  $ 65,339     $ 58,256  
Average margin balances (millions)
  $ 595     $ 528  
Average customer payable balances (millions)
  $ 988     $ 963  
Number of advisors
    1,013       960  
 
Included in the numbers above are the following relating to fee-based accounts:        
Customer household accounts
    7,263       5,705  
Average revenue per account
  $ 2,039     $ 1,734  
Ending balance of assets under administration (millions)
  $ 1,911     $ 1,342  
Average assets per active account
  $ 248,400     $ 235,232  
 
(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.

                 
   
Investment Services – Operating Results (in 000s)
Nine months ended January 31,   2005     2004  
 
Service revenue:
               
Transactional revenue
  $ 64,594     $ 74,658  
Annuitized revenue
    54,114       42,145  
 
           
Production revenue
    118,708       116,803  
Other service revenue
    19,789       26,422  
 
           
 
    138,497       143,225  
 
           
Margin interest revenue
    30,773       24,949  
Less: interest expense
    (1,930 )     (1,065 )
 
           
Net interest revenue
    28,843       23,884  
 
           
Other
    176       (731 )
 
           
Total revenues (1)
    167,516       166,378  
 
           
 
Cost of services:
               
Compensation and benefits
    84,908       73,905  
Occupancy
    16,354       15,427  
Depreciation
    3,205       5,652  
Other
    11,680       12,331  
 
           
 
    116,147       107,315  
Selling, general and administrative
    112,518       100,967  
 
           
Total expenses
    228,665       208,282  
 
           
Pretax loss
  $ (61,149 )   $ (41,904 )
 
           
 
(1) Total revenues, less interest expense.

Nine months ended January 31, 2005 compared to January 31, 2004
Investment Services’ revenues, net of interest expense, for the nine months ended January 31, 2005 increased $1.1 million, or 0.7%.

     Production revenue increased $1.9 million, or 1.6%, over the prior year. Transactional revenue decreased $10.1 million, or 13.5%, from the prior year due primarily to a 20.0% decline in transactional

-33-


 

trading volume, which was partially offset by an increase in the average revenue per trade. Annuitized revenues increased $12.0 million, or 28.4%, due to increased sales of annuities and mutual funds. The shift in revenues from transactional to annuitized demonstrates our continued move toward an advice-based focus.

     Other service revenue declined $6.6 million, or 25.1%, from the prior year due to fewer fixed income underwriting offerings and Express IRA revenues now being recorded in Tax Services.

     Margin interest revenue increased $5.8 million, or 23.3%, from the prior year, as a result of a 12.7% increase in average margin balances and higher interest rates earned. Margin balances have increased from an average of $528 million for the nine months ended January 31, 2004 to $595 million in the current period.

     Cost of services increased $8.8 million, or 8.2%, primarily due to $11.0 million of additional compensation and benefits. This increase is primarily due to a higher average commission rate than the prior year and financial incentives for new advisors. This increase was partially offset by a decline in depreciation costs as a result of building sales and asset roll offs related to the move from owned office facilities to leased facilities.

     Selling, general and administrative expenses increased $11.6 million, or 11.4%, over the prior year primarily as the result of the $6.0 million write-down of a branch office facility and an increase of $5.0 million in legal expenses.

     The pretax loss for Investment Services was $61.1 million compared to the prior year loss of $41.9 million.

Fiscal 2005 outlook
In our April 30, 2004 Form 10-K we indicated we believed a key to this segment's profitability was the recruitment and retention of experienced financial advisors. Our recruiting efforts during the year have improved. However, advisor attrition remains consistent with industry levels and, as a result, recruitment efforts have been fully offset by attrition rates that were higher than planned. We have expanded our partner programs with Tax Services, and have both licensed and unlicensed tax professionals teamed with financial advisors. We are planning for improvements in this business as we better align this segment’s cost structure with its revenue stream. Given our performance to date and revised internal forecasts, we expect our fiscal year 2005 pretax loss to be approximately 25% larger than the prior year.

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.

-34-


 

                                 
   
Corporate – Operating Results (in 000s)
  Three months ended January 31, Nine months ended January 31,
    2005     2004     2005     2004  
 
Operating revenues
  $ 3,425     $ 2,332     $ 10,290     $ 7,313  
Eliminations
    (2,123 )     (1,642 )     (6,833 )     (4,607 )
 
                       
Total revenues
    1,302       690       3,457       2,706  
 
                       
Corporate expenses:
                               
Compensation and benefits
    1,747       2,828       7,869       6,827  
Interest expense
    20,936       18,764       55,672       52,119  
Other
    10,530       9,738       27,466       20,083  
 
                       
 
    33,213       31,330       91,007       79,029  
 
                       
Support departments:
                               
Information technology
    29,023       30,745       81,435       80,696  
Marketing
    46,030       44,513       57,292       52,607  
Finance
    9,107       8,406       26,620       24,140  
Other
    31,584       22,843       78,179       50,858  
 
                       
 
    115,744       106,507       243,526       208,301  
 
                       
Allocation of support departments
    (117,297 )     (106,593 )     (245,096 )     (208,391 )
Other income, net
    18,399       1,227       20,575       3,481  
 
                       
Pretax loss
  $ (11,959 )   $ (29,327 )   $ (65,405 )   $ (72,752 )
 
                       
 

Three months ended January 31, 2005 compared to January 31, 2004
Corporate expenses increased $1.9 million primarily due to higher interest expense, resulting from higher interest rates and higher average debt balances.

     Other support department expenses increased $8.7 million, primarily due to $5.7 million of additional stock-based compensation expenses and increases in the cost of employee insurance and supply sales to franchises.

     Other income increased $17.2 million primarily as a result of a $16.7 million legal recovery we received during the current quarter.

     The pretax loss was $12.0 million, compared with last year’s third quarter loss of $29.3 million.

     Due to the nature of this segment, the three months ended January 31, 2005 are not comparable to the three months ended October 31, 2004 and are not indicative of the expected results for the entire fiscal year.

Nine months ended January 31, 2005 compared to January 31, 2004
Corporate expenses increased $12.0 million primarily due to increases in consulting and insurance costs, as well as increased allocations from the information technology, legal and human resource departments.

     Marketing department expenses increased $4.7 million, or 8.9%, primarily due to additional marketing efforts in the current year. Other support department expenses increased $27.3 million, primarily due to $14.1 million of additional stock-based compensation expenses, increases in the cost of employee insurance and additional supply sales to the operating segments.

     Other income increased $17.1 million primarily as a result of the $16.7 million legal recovery we received during the current year.

     The pretax loss was $65.4 million, compared with last year’s loss of $72.8 million.


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.

-35-


 

     Cash From Operations. Cash used in operations totaled $1.6 billion and $1.0 billion for the nine months ended January 31, 2005 and 2004, respectively. The increase in cash used in operating activities is primarily due to increases in receivables, principally participations in RALs, and income tax payments. RAL participation receivables increased over the prior year due to a higher dollar amount of loans in which we purchased participation interests, resulting from increases in the fee charged by the lender, our clients’ average refund size and the maximum loan amount allowed by the lender. Income tax payments totaled $406.6 million during the current year, an increase of $161.2 million over the prior year, due to a change in a tax accounting method, which resulted in the acceleration of taxable income within our Mortgage Services segment.

     Issuance of Common Stock. We issue shares of common stock, in accordance with our stock-based compensation plans, out of treasury shares. Proceeds from the issuance of common stock totaled $119.9 million and $111.2 million for the nine months ended January 31, 2005 and 2004, respectively.

     Debt. In August 2004 we filed an additional shelf registration statement with the SEC for up to $1.0 billion in debt securities. On October 26, 2004, we issued $400.0 million of 5.125% Senior Notes under our shelf registration statements. The Senior Notes are due on October 30, 2014, and are not redeemable by the bondholders prior to maturity. The proceeds from the notes were used to repay our $250.0 million in 6-3/4% Senior Notes, which were due on November 1, 2004. The remaining proceeds were used for working capital, capital expenditures, repayment of other debt and other general corporate purposes.

     As of January 31, 2005, we had commercial paper borrowings of $1.5 billion outstanding. Commercial paper issuance supports RAL participations and various other cash requirements.

     Dividends. Dividends paid totaled $106.4 million and $103.5 million for the nine months ended January 31, 2005 and 2004, respectively.

     Share Repurchases. On June 9, 2004, our Board of Directors approved an authorization to repurchase 15 million shares. This authorization is in addition to the authorization of 20 million shares on June 11, 2003. During the nine months ended January 31, 2005, we repurchased 11.2 million shares pursuant to these authorizations at an aggregate price of $527.5 million or an average price of $46.98 per share. There are 15.1 million shares remaining under these authorizations at January 31, 2005. We plan to continue to purchase shares on the open market in accordance with these authorizations, subject to various factors including the price of the stock, the availability of excess cash, our ability to maintain liquidity and financial flexibility, securities laws restrictions and other investment opportunities available.

     Restricted Cash. We hold certain cash balances that are restricted as to use. Cash and cash equivalents - restricted totaled $535.3 million at January 31, 2005. Investment Services held $520.0 million of this total segregated in a special reserve account for the exclusive benefit of customers. Restricted cash of $15.3 million at January 31, 2005 held by Business Services is related to funds held to pay payroll taxes on behalf of its customers.

     Segment Cash Flows. A condensed consolidating statement of cash flows by segment for the nine months ended January 31, 2005 follows. Generally, interest is not charged on intercompany activities between segments.

                                                 
                                            (in 000s)  
 
    Tax     Mortgage     Business     Investment             Consolidated  
    Services     Services     Services     Services     Corporate     H&R Block  
 
Cash provided by (used in):                                        
Operations
  $ (1,128,154 )   $ 42,964     $ (870 )   $ (52,492 )   $ (446,699 )   $ (1,585,251 )
Investing
    (77,825 )     62,511       (23,892 )     13,906       (22,980 )     (48,280 )
Financing
                (19,462 )           1,157,463       1,138,001  
Net intercompany
    1,334,086       (116,041 )     40,954       9,712       (1,268,711 )      
 

     Net intercompany activities are excluded from investing and financing activities within the segment cash flows. We believe that by excluding intercompany activities, the cash flows by segment more clearly depicts the cash generated and used by each segment. Had intercompany activities been included, those segments in a net lending situation would have been included in investing activities, and those in a net borrowing situation would have been included in financing activities.

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     Tax Services. Tax Services has historically been our largest provider of annual operating cash flows. The seasonal nature of Tax Services generally results in a large positive operating cash flow in the fourth quarter. Tax Services used $1.1 billion in its current nine-month operations to cover off-season costs and working capital requirements. This segment also used $77.8 million in investing activities, primarily related to capital expenditures in connection with our real estate expansion initiative.

     Mortgage Services. This segment primarily generates cash as a result of the sale and securitization of mortgage loans and residual interests, and as its residual interests begin to cash flow. Mortgage Services provided $43.0 million in cash from operating activities and $62.5 million in cash from investing activities. Cash flows from investing activities consist of $100.3 million in cash receipts on residual interests, partially offset by $37.7 million in capital expenditures.

     Gains on sales. Gains on sales of mortgage assets totaled $565.0 million, with the cash received primarily recorded as operating activities. The percentage of cash proceeds we receive from our capital market transactions, which are included within the gains on sales of mortgage assets, is reconciled below.

                 
            (in 000s)  
   
Nine months ended January 31,   2005     2004  
 
Cash proceeds:
               
Whole loans sold by the Trusts
  $ 544,954     $ 529,521  
Residual cash flows from Beneficial Interest in Trusts
    142,783       123,834  
Loans securitized
    53,181       115,041  
Gain on derivative instruments
    24,544        
 
           
 
    765,462       768,396  
 
           
Non-cash:
               
Retained mortgage servicing rights
    94,570       64,265  
Additions to balance sheet (1)
    16,470       63,545  
 
           
 
    111,040       127,810  
 
           
Portion of gain on sale related to capital market transactions
    876,502       896,206  
 
           
Other items included in gain on sale:
               
Changes in beneficial interest in Trusts
    (7,981 )     14,658  
Impairments to fair value of residual interests
    (8,304 )     (26,048 )
Net change in fair value of derivative instruments
    4,282       (4,297 )
Direct origination and acquisition expenses, net
    (299,549 )     (208,315 )
 
           
 
    (311,552 )     (224,002 )
 
           
Reported gains on sales of mortgage assets
  $ 564,950     $ 672,204  
 
           
Percent of gain on sale related to capital market transactions received as cash (2)
    87 %     86 %
 

(1) Includes residual interests and interest rate caps.
(2) Cash proceeds divided by portion of gain on sale related to capital market transactions.


     Warehouse Funding. To finance our prime originations, we utilize an on-balance sheet warehouse facility with capacity up to $25 million. This annual facility bears interest at one-month LIBOR plus 140 to 200 basis points. As of January 31, 2005 and April 30, 2004 the balance outstanding under this facility was $4.4 million and $4.0 million, respectively.

     To fund our non-prime originations, we utilize five off-balance sheet warehouse Trusts. The facilities used by the Trusts had a total capacity of $9.0 billion as of January 31, 2005. The Mortgage Services segment is planning to implement a $3.0 billion on-balance sheet commercial paper conduit program during fiscal year 2006. At that time, we plan to reduce the warehouse facilities to $7.0 billion. This will bring total available warehouse capacity to approximately $10.0 billion.

     We believe the sources of liquidity available to the Mortgage Services segment are sufficient for its needs.

     Business Services. Business Services funding requirements are largely related to receivables for completed work and “work in process.” We provide funding sufficient to cover their working capital needs. This segment used $0.9 million in operating cash flows during the first nine months of the year. Business Services also used $23.9 million and $19.5 million in investing and financing activities,

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respectively. Investing activities included acquisitions and capital expenditures, while financing activities consist of payments on acquisition debt.

     Investment Services. Investment Services, through HRBFA, is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers.

     At January 31, 2005, HRBFA’s net capital of $118.8 million, which was 18.0% of aggregate debit items, exceeded its minimum required net capital of $13.2 million by $105.6 million. During the current year, we contributed additional capital of $17.0 million, even though HRBFA was in excess of the minimum net capital requirement, and we may continue to do so in the future.

     In the first nine months of fiscal year 2005, Investment Services used $52.5 million in its operating activities primarily due to operating losses and the timing of cash deposits that are restricted for the benefit of customers. Cash provided by investing activities consists primarily of proceeds from the sale of branch offices.

     Liquidity needs relating to client trading and margin-borrowing activities are met primarily through cash balances in client brokerage accounts and working capital. We believe these sources of funds will continue to be the primary sources of liquidity for Investment Services. Stock loans have historically been used as a secondary source of funding and could be used in the future, if warranted.

     Pledged securities at January 31, 2005 totaled $53.5 million, an excess of $13.2 million over the margin requirement. Pledged securities at the end of fiscal year 2004 totaled $46.3 million, an excess of $7.9 million over the margin requirement.

     We believe the funding sources for Investment Services are stable. Liquidity risk within this segment is primarily limited to maintaining sufficient capital levels to obtain securities lending liquidity to support margin borrowing by customers.

OFF-BALANCE SHEET FINANCING ARRANGEMENTS
Substantially all non-prime mortgage loans we originate are sold daily to the Trusts. The Trusts purchase the loans from us utilizing five warehouse facilities that were arranged by us, bear interest at one-month LIBOR plus 50 to 200 basis points and expire on various dates during the year. In December 2004, the warehouse facilities were increased from $8.0 billion to $9.0 billion through February 15, 2005. This increase was pursuant to an amendment to the warehouse facility with Bank of America, N.A. (the BOA Facility) as reported on our current report on Form 8-K dated December 17, 2004, which is incorporated herein by reference.

     On February 15, 2005, the BOA Facility was amended further to extend the term through May 15, 2005 of the $1.0 billion in warehouse capacity added in December 2004. The additional $1.0 billion increases our maximum guarantee, which is equal to approximately 10% of the aggregate principal balance of mortgage loans held by the Trusts.

     There have been no other material changes in our off-balance sheet financing arrangements from those reported at April 30, 2004 in our Annual Report on Form 10-K.

COMMERCIAL PAPER ISSUANCE
We maintain unsecured CLOCs to support our commercial paper program and for general corporate purposes. During the second quarter, we replaced our $2.0 billion CLOC with two CLOCs. The two CLOCs are from a consortium of thirty-one banks. The first $1.0 billion CLOC is subject to annual renewal in August 2005, has a one-year term-out provision with a maturity date in August 2006 and has an annual facility fee of ten basis points per annum. The second $1.0 billion CLOC has a maturity date of August 2009 and has an annual facility fee of twelve basis points per annum. These lines are subject to various affirmative and negative covenants, including a minimum net worth covenant. These CLOCs are for working capital use, general corporate purposes and commercial paper back up. We obtained an additional $750.0 million line of credit for the period of January 26 to February 25, 2005 to back-up peak commercial paper issuance or use as an alternate source of funding for RAL participations. This line is subject to various covenants, substantially similar to the primary CLOCs. These CLOCs were undrawn at January 31, 2005.

     At January 31, 2005, there was $25.0 million (Canadian) of commercial paper outstanding under the H&R Block Canada commercial paper program. The Canadian issuances are supported by a credit facility provided by one

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bank in an amount not to exceed $125.0 million (Canadian). The Canadian CLOC is subject to annual renewal in December 2005. The Canadian CLOC was undrawn at January 31, 2005.

     There have been no other material changes in our commercial paper program from those reported at April 30, 2004 in our Annual Report on Form 10-K.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
There have been no material changes in our contractual obligations and commercial commitments from those reported at April 30, 2004 in our Annual Report on Form 10-K.

REGULATORY ENVIRONMENT
There have been no material changes in our regulatory environment from those reported at April 30, 2004 in our Annual Report on Form 10-K.

FORWARD-LOOKING INFORMATION
In this report, and from time to time throughout the year, we share our expectations for our future performance. These forward-looking statements are based upon current information, expectations, estimates and projections regarding the Company, the industries and markets in which we operate, and our assumptions and beliefs at that time. These statements speak only as of the date on which they are made, are not guarantees of future performance, and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results could materially differ from what is expressed, implied or forecast in these forward-looking statements. Words such as “believe,” “will,” “plan,” “expect,” “intend,” “estimate,” “approximate,” and similar expressions may identify such forward-looking statements.

     There have been no material changes in our risk factors from those reported at April 30, 2004 in our Annual Report on Form 10-K.


QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes in our market risks from those reported at April 30, 2004 in our Annual Report on Form 10-K.


CONTROLS AND PROCEDURES

Disclosure controls are procedures that are designed with the objective of ensuring that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934, such as this Form 10-Q, is recorded, processed, summarized and reported in accordance with the SEC’s rule. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer or persons performing similar functions, as appropriate, to allow timely decisions regarding disclosure.

     Our Disclosure Controls were designed to provide reasonable assurance that the controls and procedures would meet their objectives. Our management, including the CEO and CFO, does not expect that our Disclosure Controls will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable assurance of achieving the designed control objectives and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple errors or mistakes. Additionally, controls can be circumvented by the individual acts of some persons, by collusions of two or more people, or by management override of the control. Because of the inherent limitations in a cost-effective, maturing control system, misstatements due to error or fraud may occur and not be detected.

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     As of January 31, 2005, we evaluated the effectiveness of the design and operation of our Disclosure Controls. The controls evaluation was done under the supervision and with the participation of management, including our CEO and CFO.

     The evaluation of our Disclosure Controls included a review of the controls’ objectives and design, our implementation of the controls and the effect of the controls on the information generated for use in this Form 10-Q. In our Form 10-K for the year ended April 30, 2004, we reported various control weaknesses related to our corporate tax accounting function. These weaknesses related specifically to the reconciliation and level of detailed support of both current and deferred income tax accounts. We also determined an acceleration of taxable income was warranted in one of our segments, although there was no change to our total income tax provision. Upon identification of these control weaknesses, immediate corrective action was undertaken. Remediation that was complete or substantially complete at January 31, 2005 included the following:

•   Two additional tax directors have been added to our corporate tax department. Each has significant federal, state and local tax experience and one director also has tax GAAP experience. Where necessary, we have retained outside experts to supplement our core knowledge of the complexities around mortgage securitizations. These resources, when combined with our existing resources, will enable the department to serve the technical needs of the enterprise.
 
•   A formal policy governing all key aspects of accounting for income taxes has been developed and adopted. Departmental procedures are being revised to conform to the provisions of the policy.
 
•   The corporate controller’s department and the corporate tax department are focused on communicating more effectively with an increased concentration on the financial reporting aspects of tax items.
 
•   The corporate tax department is now an active participant in the quarterly results review meetings with our business segment leaders. During these meetings, leaders engage in a detailed review of quarterly financial statements.
 
•   Detailed, entity-specific support for all components of deferred taxes is being compiled as of the last audited financial statement date, and will be updated through the most recent calendar year end.

     Our efforts to strengthen financial and internal controls continue. We expect these efforts to be completed by the end of fiscal year 2005.

     Based on this evaluation, other than the item described above, our CEO and CFO have concluded these controls are effective. There have been no significant changes in internal controls, or in other factors, which would significantly affect these controls subsequent to the date of evaluation.      


PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The information below should be read in conjunction with the information included in note 12 to our condensed consolidated financial statements.

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 for the year ended April 30, 2004, certain events and information regarding lawsuits throughout the country regarding our refund anticipation loan programs (collectively, “RAL Cases”). The RAL Cases have involved a variety of legal theories asserted by plaintiffs. These theories include allegations that, among other things: disclosures in the RAL applications were inadequate, misleading and untimely; the RAL interest rates were usurious and unconscionable; we did not disclose that we would receive part of the finance charges paid by the customer for such loans; breach of state laws on credit service organizations; breach of contract, unjust enrichment, unfair and deceptive acts or practices; violations of the federal Racketeer Influenced and Corrupt Organizations (RICO) Act; violations of the federal Fair Debt Collection Practices Act; and that we owe and breached a fiduciary duty to our customers in connection with the RAL program.

     The amounts claimed in the RAL Cases have been substantial in some instances. We have successfully defended against numerous RAL Cases, although several of the RAL Cases are still pending. Of these RAL

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Cases that are no longer pending, some were dismissed on our motions for dismissal or summary judgment and others were dismissed voluntarily by the plaintiffs after denial of class certification. Other cases were settled, with one settlement resulting in a pretax expense of $43.5 million in fiscal year 2003 (the “Texas RAL Settlement”).

     We continue to believe we have meritorious defenses to the RAL Cases, and we intend to defend the remaining RAL Cases vigorously. There can be no assurances, however, as to the outcome of the pending RAL Cases individually or in the aggregate. Furthermore, there can be no assurances regarding the impact of the RAL Cases on our consolidated financial statements. The following is updated information regarding the pending RAL Cases in which developments occurred during or after the three months ended January 31, 2005:

     Lynne A. Carnegie, et al. v. Household International, Inc., H&R Block, Inc., et al., (formerly Joel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., Block Financial Corporation, et al.) Case No. 98 C 2178, United States District Court for the Northern District of Illinois, Eastern Division, instituted on April 18, 1998. On April 15, 2003, the District Court judge declined to approve a $25.0 million nationwide settlement of this matter, under which we and the lending bank would have each paid $12.5 million. The judge’s decision was based on a finding that counsel for the settlement plaintiffs had been inadequate representatives of the plaintiff class and failed to sustain their burden of showing that the settlement was fair. The judge subsequently appointed new counsel for the plaintiffs who filed an amended complaint and a motion for partial summary judgment. On March 29, 2004, the court either dismissed or decertified all of the plaintiffs’ claims other than part of one count alleging violations of the RICO Act. The United States Court of Appeals for the Seventh Circuit subsequently affirmed the trial court’s certification of a nationwide class on the RICO count. The case is scheduled to go to trial in October 2005. We intend to continue defending the case vigorously, but there are no assurances as to its outcome.

     Deandra D. Cummins, et al. V. H&R Block, Inc., et al., Case No. 03-C-134, Circuit Court of Kanawha County, West Virginia. On December 30, 2004, the trial court certified a class consisting of all West Virginia residents who obtained RALs from January 1, 1994 to present. On February 23, 2005, the U.S. Supreme Court denied our request to review the West Virginia Supreme Court’s decision not to review the trial court’s denial of our motion to compel arbitration. The case is scheduled to go to trial in October 2005.

     Sandra J. Basile, et al. v. H&R Block, Inc. et al., April Term 1992 Civil Action No. 3246, Court of Common Pleas, First Judicial district of Pennsylvania, Philadelphia County, instituted on April 23, 1993. On February 3, 2005, the Pennsylvania appellate court granted plaintiff’s motion for en banc review of the appellate court’s previous three-judge panel decision denying plaintiff’s appeal of the trial court class decertification. Re-argument is expected to occur in June 2005.

Peace of Mind Litigation

Lorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Civil Action 2002L000004, Circuit Court of Madison County, Illinois, is a class action case filed on January 18, 2002, as to which the court granted plaintiffs’ first amended motion for class certification on August 27, 2003. Plaintiffs’ claims consist of five counts relating to the defendants’ Peace of Mind program under which the applicable tax return preparation subsidiary assumes liability for the cost of additional tax assessments attributable to tax return preparation error. The plaintiffs allege that defendants’ sale of its Peace of Mind guarantee constitutes statutory fraud by selling insurance without a license, an unfair trade practice by omission and by “cramming” (i.e., charging customers for the guarantee even though they did not request it and/or did not want it), and constitutes a breach of fiduciary duty. In August 2003, the court certified the following plaintiff classes: (1) all persons who were charged a separate fee for Peace of Mind by “H&R Block” or a defendant H&R Block class member from January 1, 1997 to final judgment; (2) all persons who reside in certain class states and who were charged a separate fee for Peace of Mind by “H&R Block,” or a defendant H&R Block class member, and that was not licensed to sell insurance, from January 1, 1997 to final judgment; and (3) all persons who had an unsolicited charge for Peace of Mind posted to their bills by “H&R Block,” or a defendant H&R Block class member from January 1, 1997, to final judgment. Among those excluded from the plaintiff classes are all persons who received the Peace of Mind guarantee through an H&R Block Premium office and all persons who reside in Texas and Alabama. The court also certified a defendant class consisting of any entity with the names “H&R Block” or “HRB”

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in its name, or otherwise affiliated or associated with H&R Block Tax Services, Inc., and which sold or sells the Peace of Mind product. The trial court subsequently denied the defendants’ motion asking the trial court to certify the class certification issues for interlocutory appeal. Discovery is proceeding. No trial date has been set.

     There is one other putative class action pending against us in Texas that involves the Peace of Mind guarantee. This case is being tried before the same judge that presided over the Texas RAL Settlement and involves the same plaintiffs attorneys that are involved in the Marshall litigation in Illinois and substantially similar allegations. No class has been certified in this case.

     We believe the claims in these Peace of Mind actions are without merit and we intend to defend them vigorously. However, there can be no assurances as to the outcome of these pending actions individually or in the aggregate, and there can be no assurances on the impact of these actions on our consolidated financial statements.

Other Claims and Litigation

As with other broker-dealers, HRBFA has been the subject of an investigation by the National Association of Securities Dealers, Inc. (NASD) regarding the market timing of mutual funds. The investigation concerned the trading activity by two former financial advisors, primarily on behalf of one of HRBFA’s institutional clients. After substantive discussions with the NASD, HRBFA agreed to a settlement of the matter, without admitting or denying any wrongdoing. We paid a fine of $500,000 and $325,000 restitution, to mutual fund customers.

     As reported in a current report on Form 8-K dated November 8, 2004, the NASD brought charges against HRBFA related to the sale by HRBFA of Enron debentures in 2001. Two private civil actions subsequently were filed against HRBFA concerning the matter raised in the NASD’s charges, one of which was subsequently dismissed without prejudice. We intend to defend the charges and the civil suit vigorously. There can be no assurances as to the outcome and resolution of this matter.

     As part of an industry-wide review, the Internal Revenue Service (IRS) is investigating tax-planning strategies that certain RSM clients utilized during fiscal years 2000 through 2003. Specifically, the IRS is examining these strategies to determine whether RSM complied with tax shelter registration and listing regulations and whether such strategies were appropriate. If the IRS were to determine that these strategies were inappropriate, clients that utilized the strategies could face penalties and interest for underpayment of taxes and may attempt to seek recovery from RSM. There can be no assurances as to the outcome of this matter.

     As reported in current report on Form 8-K dated December 12, 2003, the United States SEC informed outside counsel to the Company on December 11, 2003 that the Commission had issued a Formal Order of Investigation concerning our disclosures, in and before November 2002, regarding RAL litigation to which we were and are a party. There can be no assurances as to the outcome and resolution of this matter.

     We have from time to time been party to claims and lawsuits not discussed herein arising out of our business operations. These claims and lawsuits include actions by individual plaintiffs, as well as cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. Some of these claims and lawsuits pertain to RALs, the electronic filing of customers’ income tax returns and the Peace of Mind guarantee program. We believe we have meritorious defenses to each of these claims, and we are defending, or intend to defend, them vigorously, although there is no assurance as to their outcome.

     In addition to the aforementioned types of cases, we are parties to claims and lawsuits that we consider to be ordinary, routine litigation incidental to our business, including claims and lawsuits (Other Claims) concerning investment products, the preparation of customers’ income tax returns, the fees charged customers for various products and services, losses incurred by customers with respect to their investment accounts, relationships with franchisees, denials of mortgage loans, contested mortgage foreclosures, other aspects of the mortgage business, intellectual property disputes, and contract disputes. We believe we have meritorious defenses to each of the Other Claims, and we are defending, or intend to defend, them vigorously. While we cannot provide assurance that we will ultimately prevail in each instance, we believe the amount, if any, we are required to pay in the discharge of liabilities or

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settlements in these Other Claims will not have a material adverse effect on our consolidated financial statements.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES

A summary of our purchases of H&R Block common stock during the third quarter of fiscal year 2005 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
    2     $ 49.22             15,104  
December 1 – December 31
        $ 48.08             15,104  
January 1 – January 31
    4     $ 47.40             15,104  
 
(1) All shares purchased during the current quarter 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 11, 2003 and June 9, 2004, our Board of Directors approved the repurchase of 20 million shares and 15 million shares, respectively, of H&R Block, Inc. common stock. These authorizations have no expiration dates.

ITEM 6. EXHIBITS

     
10.1
  Termination Agreement dated January 7, 2005, between H&R Block, Inc., H&R Block Financial Advisors, Inc. and Brian L. Nygaard.
 
   
10.2
  Fourth Amended and Restated Refund Anticipation Loan Participation Agreement dated as of December 31, 2004, between Block Financial Corporation, HSBC Taxpayer Financial Services Inc. and Household Tax Masters Acquisition Corporation.
 
   
10.3
  Second Amended and Restated Loan Purchase and Contribution Agreement dated as of November 14, 2003 between Option One Loan Warehouse Corporation and Option One Mortgage Corporation.
 
   
10.4
  Amended and Restated Sales and Servicing Agreement dated November 12, 2004 among Option One Owner Trust 2003-5, Option One Loan Warehouse Corporation, Option One Mortgage Corporation and Wells Fargo Bank, N.A.
 
   
10.5
  Note Purchase Agreement dated November 14, 2003 between Option One Owner Trust 2003-5, Option One Loan Warehouse Corporation and Citigroup Global Markets Realty Corp.
 
   
10.6
  Amendment Number One to the Note Purchase Agreement, dated November 14, 2004, among Option One Owner Trust 2003-5, Option One Loan Warehouse Corporation and Citigroup Global Markets Realty Corp.
 
   
10.7
  Indenture dated as of November 1, 2003 between Option One Owner Trust 2003-5 and Wells Fargo Bank Minnesota, National Association.
 
   
10.8
  Amended and Restated Sale and Servicing Agreement dated as of November 25, 2003 among Option One Owner Trust 2001-2, Option One Loan Warehouse Corporation, Option One Mortgage Corporation and Wells Fargo Bank Minnesota, National Association.
 
   
10.9
  Amendment Number One to the Amended and Restated Sale and Servicing Agreement, dated as of April 30, 2004, among Option One Owner Trust 2001-2, Option One Loan Warehouse Corporation, Option One Mortgage Corporation and Wells Fargo Bank Minnesota, National Association.
 
   
10.10
  Amendment Number Two to the Amended and Restated Sale and Servicing Agreement, dated as of December 17, 2004, among Option One Owner Trust 2001-2, Option One Loan Warehouse Corporation, Option One Mortgage Corporation and Wells Fargo Bank N.A.
 
   
10.11
  Amended and Restated Note Purchase Agreement dated as of November 25, 2003 among Option One Owner Trust 2001-2, Option One Loan Warehouse Corporation and Bank of America, N.A.
 
   
10.12
  Amendment Number One to the Amended and Restated Note Purchase Agreement, dated as of December 17, 2004, among Option One Owner Trust 2001-2, Option One Loan Warehouse Corporation and Bank of America, N.A.

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10.13
  Amendment Number Two to the Amended and Restated Note Purchase Agreement, dated as of February 15, 2005, among Option One Owner Trust 2001-2, Option One Loan Warehouse Corporation and Bank of America, N.A.
 
   
10.14
  Amended and Restated Indenture dated as of November 25, 2003 between Option One Owner Trust 2001-2 and Wells Fargo Bank Minnesota, National Association.
 
   
10.15
  Letter Agreement dated as of April 1, 2000 among Option One Mortgage Corporation, Bank of America, 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.

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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.
       
      (Registrant)
 
       
DATE 3/9/05
  BY   /s/ Mark A. Ernst
       
      Mark A. Ernst
Chairman of the Board, President and Chief
Executive Officer
 
       
DATE 3/9/05
  BY   /s/ William L. Trubeck
       
      William L. Trubeck
Executive Vice President and Chief Financial
Officer

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