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H&R Block: The Good, The Bad, The Ugly

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Another bad quarter from a bad company.

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As is tradition with H&R Block (HRB), I will start with the ugly:

The Ugly:

  • Lowlights include: Missing an already pessimistic -$0.29 earnings expectation... by 55 percent.
  • The company blamed the miss on:
    • Lower mortgage revenues: $141 million vs. $246 million for the same period '05 and down from $170 million in the first quarter. "Primarily a result of industry wide conditions that have resulted in further declines in origination volumes, as well as lower gains on sales, due to lower than expected loan sale premiums and higher provisions for loan losses."
    • Loan loss provisions totalled 69 bps versus the 40 bps expected.
    • The gain on sale margin declined to 37 basis points compared with 63 basis points a year ago and 81 basis points in the first quarter.
    • Translation: The mortgage market stinks; people want fewer loans and the ones that want them are worse risks.
    • Derivative Losses: -$29 million versus $13 million in 1Q and $55 million 2Q last year. Usually these are offset by higher loan sale premiums. They were impacted by higher credit risk allowances demanded by the loan buyers.
    • Increased exposure to non-prime mortgage market: Mortgage loans held for investment increased to $684 million, reflecting further growth of HRB Bank. More worrisome are mortgage loans held for sale increased to $432 million, due to the increase in early payments defaults and resulting loan repurchase requirements (bascially the company was forced to buy back crappy loans).
    • Poor quality of the mortgage market should have people rethinking the sale price the company could get for the Option One business.
  • The most worrisome aspect going forward is ignoring all the sound and fury surrounding the mortgage business (which is essentially a diversion because if the company follows through on its plans it will no longer be in the mortgage business) the core tax business showed decided weakness.
    • Due to heightened competition from Jackson Hewitt and online services, the company is pushing forward tax season in a bid for customer retention, offering an Instant Money Advance Loan, similar to its Refund Anticipation Loan, but it's offered earlier in the season. Also, it does not require the submission of a W-2 form. It is in response to Jackson Hewitt's "Money Now" pay-stub RAL.
    • In order to market the loan, HRB opened roughly 1,500 company owned offices in November versus 500-800 last year. It expanded the early season hours of its roughly 3,000 franchised offices.
    • Net result: What do you think? Costs went up and income went down. Loss from tax services increased to $167 million from $142 million y-o-y.
    • Management was particulary fuzzy about how the tax season should play out. Mitigating factor: Given the history of mismanagement, it doesn't really matter. They often find ways to screw things up. Markets seem to expect this.


The Merely Bad:

  • The company is closing 12 underperforming Option One offices.
    • This should result in about $22 million in charges in the 3Q.
  • HRB Financial Advisors, HRB Mortgage and HRB Bank are almost profitable.
  • Share repurchases came in at a little more than half of what was expected.
    • Maybe even the company thinks its shares are expensive at these prices.


The Good:

  • Management confirmed that Mortgage Book Value was roughly $1.3 billion.
    • This means the company might be able to sell its mortgage business for about $1 billion.
    • Mitigating factor: Rising NPLs, credit costs--in a credit crunch this valuation will go lower.
  • Easy comps from last year's tax season.
  • Management retained its recently reduced F2007 eps guidance of $1.20-$1.45.


Conclusion:

Another bad quarter from a bad company. Again, assuming that the mortgage business gets sold, core trends in the tax business are not good. Results were weak in Tax and Business services as a result of higher costs and marketing initiatives are aimed at stronger branding and client retention. The company is pulling forward the tax season each year due to higher competition from Hewitt and online services. To remain competitive, Block is going to have to open new offices, open them earlier and offer newer, more sophisticated loan products, which will increase both financial and regulatory risk. The end result of all of this, in my estimation, will result in lower margins.

Add into all of this a company that is pretty fully valued to extremely overvalued, on just about any metric.

Steve Zausner contributed to this article.

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Position in HRB

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