HRB

Business Context and Reporting Period

Company: H&R Block, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: January 31, 2007 (Third Quarter of Fiscal Year 2007)
Business Overview: H&R Block provides tax preparation services, business consulting, and consumer financial services (brokerage and banking). The reporting period is heavily influenced by the seasonal nature of tax services and significant strategic changes regarding its mortgage operations.

Key Financial Metrics

Note: Amounts in millions unless otherwise noted. Discontinued operations relate to Option One Mortgage Corporation (OOMC) and H&R Block Mortgage Corporation (HRBMC).

Material Changes vs. Prior Period

• Discontinued Operations Impact: The most significant change is the classification of mortgage operations (OOMC/HRBMC) as "discontinued operations" following the Board's approval to sell the business. This resulted in a net loss of $85.2 million for the quarter and $119.1 million for the nine-month period, compared to net income of $42.4 million and $155.3 million in the prior year periods. This shift was driven by higher loan repurchase reserves ($111.1 million provision in Q3) and impairments of residual interests.
• Tax Services Growth: Revenues increased 14.5% year-over-year for the quarter, driven by a 7.6% increase in the net average fee per client and higher loan participation fees from the new Instant Money Advance Loan (IMAL) product. Pretax income for this segment turned positive ($59.3 million) compared to a loss of $6.3 million in the prior year, aided by the absence of $71.7 million in litigation settlement charges recorded in the prior year.
• Business Services: Revenues decreased 8.5% for the quarter due to organizational restructuring following the American Express acquisition, though nine-month revenues increased 22.8% due to the acquisition's inclusion.
• Consumer Financial Services: Revenues increased 31.2% for the quarter, with the segment reporting a pretax income of $11.0 million versus a loss of $7.7 million in the prior year. This was driven by higher financial advisor production revenue and net interest revenue from HRB Bank.

Guidance, Outlook, Risks, and Unusual Items

• Regulatory Compliance: The company fell below the Office of Thrift Supervision (OTS) minimum ratio of adjusted tangible capital to adjusted total assets (approx. 1% vs. 3% required) due to mortgage losses and seasonal fluctuations. Management submitted a corrective action plan to the OTS, expecting compliance by February 28, 2007.
• Internal Controls: Management concluded that disclosure controls and procedures were not effective as of January 31, 2007, due to a material weakness in the valuation of residual interests in securitizations. Management believes this weakness was remediated by March 12, 2007.
• Litigation Risks: Significant ongoing litigation includes Refund Anticipation Loan (RAL) cases, Peace of Mind (POM) guarantee class actions, and securities class actions alleging misleading financial statements. While the company believes it has meritorious defenses, the ultimate cost is difficult to predict.
• Mortgage Covenant Waivers: OOMC failed to meet the "minimum net income" financial covenant in eight warehouse facilities. Waivers were obtained through April 27, 2007. Failure to obtain future waivers could terminate funding obligations.
• Seasonality: Management notes that interim results for Tax Services are not indicative of full-year results due to the seasonal peak in January through April.

Investor Verification Checklist

• Discontinued Operations Valuation: Verify the assumptions used for loan repurchase reserves and the impairment of residual interests in the discontinued mortgage segment, as these drove the majority of the current period loss.
• Regulatory Capital Status: Confirm the company's status regarding the OTS tangible capital ratio requirement as of the subsequent period (post-February 28, 2007).
• Internal Control Remediation: Review the specific steps taken to remediate the material weakness in financial reporting regarding residual interest valuation.
• Litigation Exposure: Monitor developments in the RAL and POM class action lawsuits for any new settlements or adverse rulings that could impact future reserves.
• Mortgage Sale Progress: Track the status of the planned sale of OOMC and HRBMC to ensure the transaction closes and the discontinued operations classification remains appropriate.