HRB

H&R Block, Inc. 10-Q Summary: Period Ended January 31, 2008

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended January 31, 2008, and the nine months ended on that date. H&R Block, Inc. operates primarily through three segments: Tax Services, Business Services, and Consumer Financial Services. The reporting period is heavily influenced by the company's decision to terminate its mortgage origination business (Option One Mortgage Corporation) and classify it as discontinued operations. The company also announced a corporate cost reduction program to eliminate approximately $110 million in annual expenses.

Key Financial Metrics

Material Changes vs. Prior Period

• Discontinued Operations Impact: The significant increase in net loss is primarily driven by the mortgage business classified as discontinued operations. This segment recorded a net loss of $615.6 million, compared to $131.2 million in the prior year. This includes $116.3 million in asset impairments and $379.4 million in loan repurchase reserves.
• Continuing Operations Loss: Continuing operations also reported a loss of $236.6 million, an increase from $216.9 million in the prior year. This was driven by higher bad debt expenses in Tax Services related to refund anticipation loans (RALs) and the Emerald Advance program, as well as corporate restructuring charges.
• Debt Structure: Total debt increased significantly. The company issued $600 million in Senior Notes in January 2008 and increased borrowings under committed lines of credit (CLOCs) to $1.8 billion to replace commercial paper, which was no longer being issued due to market conditions.
• Segment Performance:
  • Tax Services: Revenues increased 6.1% to $822.5 million, but pretax loss widened to $325.6 million due to increased bad debt provisions.
  • Business Services: Revenues were flat at $623.8 million, but pretax income improved to $16.5 million from a loss of $4.7 million.
  • Consumer Financial Services: Revenues increased 14.9% to $332.7 million, with pretax income rising to $10.1 million.

Guidance, Outlook, Risks, and Contingencies

• Regulatory Capital: The company is currently below the 3% minimum adjusted tangible capital ratio required by the Office of Thrift Supervision (OTS) for its banking subsidiary. The company is seeking modification or elimination of this requirement following the cessation of its mortgage business. Failure to comply could result in regulatory actions or asset sales.
• Liquidity: The company has ceased issuing commercial paper and is relying on $2.0 billion in revolving credit facilities. It maintains $1.8 billion in outstanding borrowings under these facilities.
• Legal Proceedings: Significant litigation risks remain regarding Refund Anticipation Loans (RALs), the Peace of Mind (POM) guarantee program, and Express IRA marketing practices. The company believes it has meritorious defenses but acknowledges potential material adverse effects if outcomes are unfavorable.
• Outlook: Management expects retail client growth of zero to two percent for the full fiscal year. The tax season was delayed due to late Alternative Minimum Tax (AMT) legislation, shifting revenue from the third to the fourth quarter.

Investor Verification Checklist

• Discontinued Operations Valuation: Verify the assumptions used for the $304.9 million valuation allowance on mortgage assets held for sale and the potential for further impairments.
• Regulatory Compliance: Monitor the status of the OTS Supervisory Directive and the company's ability to meet or negotiate the 3% tangible capital ratio requirement.
• Loan Repurchase Reserves: Review the adequacy of the $69.0 million reserve for loan repurchases, particularly given the increased loss severity assumption (50%) for discontinued mortgage operations.
• Bad Debt Trends: Assess the trajectory of bad debt expenses in the Tax Services segment related to the Emerald Advance and RAL programs.
• Liquidity Covenants: Confirm compliance with debt covenants, specifically the adjusted net worth requirement of $450 million under the amended CLOCs.