HRB

H&R Block, Inc. 10-Q Summary

Business Context and Reporting Period

This is a Quarterly Report (Form 10-Q) for H&R Block, Inc. for the period ended October 31, 2008. The company operates in three primary segments: Tax Services, Business Services (RSM McGladrey), and Consumer Financial Services (H&R Block Bank). A significant event during this period was the announcement and subsequent completion of the sale of H&R Block Financial Advisors, Inc. (HRBFA) to Ameriprise Financial, Inc., effective November 1, 2008. Consequently, HRBFA results are presented as discontinued operations.

Key Financial Metrics

Revenue and Profit (Six Months Ended Oct 31, 2008):

• Total Revenues: $623.4 million (Continuing Operations).
• Net Loss (Continuing Operations): $261.6 million.
• Net Loss (Discontinued Operations): $7.0 million.
• Total Net Loss: $268.6 million.
• Loss Per Share (Diluted): $0.82.

Cash Flow and Liquidity:

• Cash and Cash Equivalents: $693.6 million (as of Oct 31, 2008).
• Net Cash Used in Operating Activities: $665.9 million.
• Net Cash Provided by Financing Activities: $743.5 million (driven by short-term borrowings and stock issuance).
• Long-Term Debt: $1.73 billion (includes $693.6 million in CLOC borrowings).

Segment Performance (Six Months):

• Tax Services: Revenue $174.4 million; Pretax Loss $348.5 million.
• Business Services: Revenue $407.7 million; Pretax Income $12.8 million.
• Consumer Financial Services: Revenue $35.8 million; Pretax Loss $32.7 million.

Material Changes vs. Prior Period

Discontinued Operations Impact: The prior year period (six months ended Oct 31, 2007) included massive losses from the mortgage business (now discontinued), resulting in a total net loss of $804.9 million. The current period's total net loss of $268.6 million is significantly lower, primarily due to the exclusion of these discontinued mortgage losses.

Consumer Financial Services Deterioration: The banking segment shifted from a pretax income of $0.4 million in the prior year to a pretax loss of $32.7 million. This was driven by a $38.1 million provision for loan losses on mortgage loans held for investment, compared to $11.9 million in the prior year. The loan loss reserve increased to 7.27% of the portfolio.

Tax Services Improvement: Despite seasonal losses, the Tax Services segment reduced its pretax loss from $371.4 million to $348.5 million. Revenue increased 8.5% due to a 13.3% increase in U.S. retail clients served. Bad debt expense on Refund Anticipation Loans (RALs) decreased by $11.3 million compared to the prior year.

Capital Structure: On October 27, 2008, the company sold 8.3 million shares of common stock for net proceeds of $141.6 million to maintain equity levels required by credit facilities.

Guidance, Outlook, Risks, and Contingencies

Outlook and Management Commentary: Management notes that operating revenues are highly seasonal, with peak revenues occurring January through April. The company utilized its credit facilities to fund off-season operating losses. The sale of HRBFA is expected to result in a gain of less than $10 million in the quarter ending January 31, 2009.

Key Risks and Contingencies:

• Mortgage Portfolio Quality: The company faces significant exposure to declining home prices and increasing delinquencies. Approximately 49% of the mortgage loan portfolio is concentrated in Florida, California, and New York. Impaired loans totaled $150.8 million.
• Liquidity Constraints: Lehman Brothers Bank, a participating lender in the company's $2.0 billion credit facility, declared bankruptcy. While the company does not expect a material impact, Lehman's failure effectively reduced available liquidity by $50 million.
• Legal Proceedings:
  • RAL Litigation: Numerous lawsuits regarding Refund Anticipation Loans; loss estimates cannot be determined.
  • Peace of Mind (POM) Litigation: Class action regarding insurance licensing and "cramming" of fees; geographic scope reduced to 13 states.
  • Express IRA Litigation: Lawsuits regarding fraudulent business practices; company remains liable via indemnification after the sale of HRBFA.
  • Mortgage Repurchase Liability: Liability for loans previously sold by Sand Canyon Corporation (SCC) stands at $224.7 million.

Investor Verification Checklist

• Verify the adequacy of the loan loss reserve (7.27%) given the high concentration of loans in distressed housing markets (FL, CA, NY) and the 11.65% delinquency rate.
• Monitor the status of the Lehman Brothers credit facility and any potential further reductions in liquidity or increases in borrowing costs.
• Review the progress of litigation settlements, specifically the RAL and Peace of Mind cases, as potential liabilities are substantial and unquantified.
• Assess the impact of the sale of HRBFA on future revenue streams and the realization of the expected tax capital loss.
• Confirm the company's ability to meet the $650 million net worth covenant on its credit facilities during the off-season.