HRB

H&R Block, Inc. 10-Q Summary

Business Context and Reporting Period

This filing is a Quarterly Report on Form 10-Q for the period ended January 31, 2009. H&R Block, Inc. operates primarily through three segments: Tax Services, Business Services (RSM McGladrey), and Consumer Financial Services (H&R Block Bank). The company recently completed the sale of its financial advisory business (HRBFA) to Ameriprise Financial, Inc. on November 1, 2008, which is now reported as discontinued operations. The company is a large accelerated filer incorporated in Missouri.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total revenues increased 11.0% for the three months ended Jan 31, 2009, compared to the prior year, driven primarily by a 15.1% increase in Tax Services revenues. This growth was fueled by higher tax return volumes (partially due to the acquisition of a major franchise operator) and increased average fees.
• Profitability Shift: The company reported a net income of $47.4 million for the quarter, a significant turnaround from a net loss of $47.4 million in the same period of the prior year. However, for the nine-month period, the company reported a net loss of $221.2 million, an improvement from the $852.2 million loss in the prior year, largely due to reduced losses in discontinued operations.
• Discontinued Operations: The sale of HRBFA resulted in a $12.2 million loss recorded in the quarter. Discontinued operations also include wind-down costs from the former mortgage business (Sand Canyon Corporation).
• Banking Segment Stress: The Consumer Financial Services segment reported a pretax loss of $3.3 million for the quarter (vs. $12.3 million income prior year) and a $36.0 million loss for the nine months (vs. $12.8 million income prior year). This was driven by a significant increase in the provision for loan losses on mortgage loans held for investment ($13.9 million for the quarter; $52.0 million for nine months) due to declining home prices and rising delinquencies.
• Liquidity Position: Cash and cash equivalents increased to $1.27 billion from $664.9 million at the end of the prior fiscal year. The company raised $141.5 million in net proceeds from a common stock offering in October 2008.

Guidance, Outlook, and Risks

• Seasonality: Management notes that results for interim periods are not indicative of full-year results due to the highly seasonal nature of the tax business, with peak revenues occurring between January and April.
• Outlook: Management does not expect to maintain the current level of revenue or tax return growth throughout the remainder of the tax season. The effective tax rate for the full fiscal year 2009 is expected to be approximately 40%.
• Mortgage Risks: The mortgage loan portfolio faces significant risk from declining residential home values. The allowance for loan losses increased to 8.82% of the portfolio (from 4.49% at April 30, 2008). Delinquency rates (30+ days) rose to 16.29%.
• Litigation: The company faces substantial litigation risks, including:
  • RAL Litigation: One remaining putative class action regarding Refund Anticipation Loans.
  • Peace of Mind (POM) Litigation: Class actions alleging statutory fraud and unfair trade practices regarding the tax guarantee program.
  • Express IRA Litigation: Lawsuits by New York and Mississippi Attorneys General regarding fraudulent business practices; the company remains liable via indemnification after selling HRBFA.
  • Discontinued Mortgage Litigation: Ongoing investigations and claims related to the former Sand Canyon Corporation mortgage business, including a preliminary injunction in Massachusetts limiting foreclosure actions.
• Capital Markets: The company maintains $2.0 billion in revolving credit facilities. However, the bankruptcy of Lehman Brothers Bank (a participating lender) has effectively reduced available liquidity by $50 million. The company entered a new $2.5 billion line of credit with HSBC for RAL funding.

Investor Verification Checklist

• Mortgage Loan Quality: Verify the trajectory of the loan loss provision and delinquency rates for the mortgage portfolio, specifically the concentration of loans in Florida, California, and New York.
• Discontinued Operations Indemnities: Review the estimated fair value of indemnification obligations ($15.5 million recorded) related to the HRBFA sale and potential exposure from the Reserve Primary Fund investment.
• Litigation Exposure: Assess the potential financial impact of the pending RAL, POM, and Express IRA class actions, as well as the Massachusetts foreclosure injunction.
• Liquidity Covenants: Confirm compliance with the $650 million net worth covenant required by the revolving credit facilities (current net worth is $840 million).
• Tax Season Performance: Monitor the second half of the tax season (Q4) to determine if the revenue growth and fee increases seen in Q3 are sustainable or if they were driven by the timing of peak tax days.