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, 2007. The company operates in three primary segments: Tax Services, Business Services, and Consumer Financial Services. The reporting period is heavily impacted by the classification of its mortgage operations (Option One Mortgage Corporation and H&R Block Mortgage Corporation) as discontinued operations following the termination of an agreement to sell the business to Cerberus Capital Management in December 2007.

Key Financial Metrics

Material Changes vs. Prior Period

• Discontinued Operations Impact: The most significant change is the massive loss from discontinued operations, driven by the mortgage business. Net loss from discontinued operations increased from $35.5 million (three months 2006) to $366.2 million (three months 2007). This includes a $123.0 million asset impairment charge in the quarter and $146.2 million for the six-month period.
• Continuing Operations Loss: Continuing operations also reported a loss, widening from $121.0 million (three months 2006) to $136.1 million (three months 2007). This was driven by higher bad debt expenses in Tax Services related to Refund Anticipation Loans (RALs) and increased loan loss provisions in Consumer Financial Services.
• Debt Structure: Due to negative market conditions and credit rating downgrades, the company repaid all commercial paper borrowings ($1.0 billion outstanding in Oct 2006 vs. $0 in Oct 2007) and replaced them with borrowings under committed lines of credit (CLOCs), totaling $1.6 billion outstanding as of October 31, 2007.
• Segment Performance:
  • Tax Services: Revenues increased 10.8% year-over-year, but pretax loss widened due to a $12.5 million increase in bad debt expense from RALs.
  • Business Services: Revenues increased 4.5%, and the segment returned to profitability with a pretax income of $11.8 million compared to $1.0 million in the prior year.
  • Consumer Financial Services: Revenues increased 5.6%, but the segment reported a pretax loss of $9.1 million due to a $9.8 million provision for loan losses on mortgage loans held for investment.

Guidance, Outlook, and Risks

• Mortgage Termination: The company announced the immediate termination of all mortgage origination activities. It expects to incur a total pretax restructuring charge of $74.8 million related to the closure, with $34.9 million already incurred in the quarter.
• Regulatory Capital Deficiency: H&R Block failed to meet the Office of Thrift Supervision (OTS) requirement of a 3% minimum ratio of adjusted tangible capital to adjusted total assets. The company had negative adjusted tangible capital of $644.4 million. The OTS has issued a Supervisory Directive, and the company does not expect to be in compliance by April 30, 2008.
• Liquidity Constraints: The company does not expect to repurchase treasury shares until after fiscal year 2009 due to capital requirements and operating losses. It has amended its CLOCs to lower the minimum net worth requirement to $450 million for the current and next quarter.
• Legal Contingencies: Significant litigation remains 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.
• IRS Processing Delays: Pending Congressional action on the Alternative Minimum Tax (AMT) may cause the IRS to delay tax return processing in January 2008, potentially shifting revenues to the fourth quarter and increasing operating expenses.

Investor Verification Checklist

• Capital Compliance: Verify the status of the revised capital plan submitted to the OTS and the likelihood of meeting the 3% tangible capital ratio by April 2008.
• Mortgage Asset Valuation: Review the assumptions used for the $123 million impairment charge and the valuation of remaining mortgage servicing rights and residual interests.
• Loan Loss Reserves: Assess the adequacy of the loan loss provision for mortgage loans held for investment ($15.5 million reserve) given the rising delinquency rates and declining home prices.
• Liquidity Runway: Confirm the availability of the $2.0 billion committed lines of credit and the terms of the amended covenants.
• Legal Exposure: Monitor developments in the RAL and POM class action lawsuits for potential settlement costs or judgments.