H&R Block: The Ugly, The Bad, and The "Looking for Something, Anything Good"
The quarter was an incredible screw-up, even for a company that has a history of incredible screw-ups...
Since the quarter was an incredible screw-up, even for a company that has a history of incredible screw-ups, I will break with tradition and start with…
The Ugly: The Numbers
The numbers missed consensus by a lot, despite consensus being a totally uninspiring -$0.28; H&R Block (HRB) reported a -$0.41. To put this in some context, it did -$0.09 1Q last year-so the excuse that first quarters are always seasonally weak goes out the window.
Mitigating Factor: It was not really a surprise-guidance did not reflect the 19 cent mortgage reserve announced last week-the reason the stock did not sell off post announcement, despite the numbers looking much worse than expectations.
The company reduced already anemic guidance from $1.80-$2.05 to $1.60-$1.80. The reduction was primarily related to additional provision for repurchase reserves.
It still strikes my firm as too high as it assumes default experience does not worsen from here. We think that deteriorating real estate prices and rash of ARM prepayments may lead to significantly more charges than management expects (or admits to).
Just a week ago the company reported that it was setting aside $102 million to cover losses in its sub prime mortgage lending unit. CEO Ernst expressed confidence that the expanded reserve is large enough to cover loan losses.
My firm would like to point out that this is a company that offers a wide range for earnings guidance and has still missed 4 of the past 6 quarters. I am not sure how much confidence I have in CEO Ernst's confidence.
Mitigating Factor: Consensus numbers were already within range of new guidance.
Gain on Sale Mortgage assets 2005Q: $236 mln
Gain on Sale Mortgage assets 2006Q: $63 mln
For other mortgage companies, some cryptic comments (that we already knew) from CEO Ernst:
"Wall Street firms and other loan buyers in the secondary market have become much more stringent in their enforcement of their requirements to buyback loans."
The default rate is up to 5 percent from 2 percent last year. Our view is that other mortgage lenders are facing, or will face, the same problem.
Block's tax service business, which historically incurs first-quarter losses, reported a pre-tax loss in the latest period of $153.1 million, compared with a $144.5 million loss last year. The company attributed the loss to opening 300-400 more offices nationwide
Question: why open the offices?
Management indicated that lower net income leaves room for only 17 million share repurchases; investors were certainly hoping for more.
Sale of the mortgage business is looking increasingly unlikely. CEO Ernst, during the call, discussed a lack of "strategic alternatives" for mortgages.
Net debt increased y/y by $480 million (company used to have positive net debt, meaning more cash than debt).
Outside of mortgages, other business lines "performed in line with expectations," said CEO Max Ernst.
It is not hard to perform in line with expectations when there are no expectations because your other businesses are preparing taxes and loaning money at usurious rates against tax returns and it isn't even close to tax return season.
Revenues in Business Services rose 62 percent. Giving the devil his due, this line and the acquisition from AMEX seem to be working.
Bottom-line: The announcement was really a repeat of last week's writedown (except the amount of share repurchase was disappointing), so we don't expect immediate effects. The only bull case we have heard for these guys is that they have an above T-bill FCF yield of about 5 percent. Slightly above the risk-free rate does not seem compelling to us given high mortgage risks, uncertain tax outlook, decreased ability for financial engineering, management's poor history of delivering on promises and lack of real direction in businesses.
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