Monday, December 19, 2005

H&R Block: Tax Write-off?

H&R Block Inc. (HRB - $24.22), the largest U.S. tax preparation company, restated fiscal second-quarter results last Monday, saying estimated losses from Hurricanes Katrina and Rita helped make the quarter worse than first reported.

The Company said it lost $86.3 million, or 26 cents a share, in the fiscal second quarter, well above the $72.2 million, or 22 cents-a-share, loss it originally reported in mid-November.

H&R Block's earnings are highly seasonal because of the surge in tax work between January and April and it is not unusual for the company to report losses in its first and second quarters. Management is still talking profits for full-year FY '06, and said it expects HRB to earn between $1.90 and $2.15 a share for the fiscal year.

Better known for its tax-preparation and tax-consulting services, HRB is of investing interest because approximately 50 cents of every dollar in revenue is generated by mortgage services. This operating segment is engaged in the origination of non-prime mortgage loans through an independent broker network, the sale and securitization of mortgage loans, and the servicing of non-prime loans. [ed. note. non-prime means "sub-prime," which means "high-risk."] Of the $12.6 billion in loans generated in the quarter-ended October 31, 2005, approximately 96.6% of this volume originated in sub-prime lending. Rising interest rates are pressuring margins. The Company's recently filed 10Q noted that despite increases in loan origination volume, gains on sales of mortgage loans decreased $120.2 million, primarily as a result of rapidly rising two-year swap rates, additional credit enhancement requirements by rating agencies and moderating demand by loan buyers. Net margins fell to (0.20)% from 1.14% last year.
HRB is counting on its mortgage origination unit to be a continuing strong driver of top-line growth. For the second half of fiscal year 2006, management believes that the Company can achieve funding volumes consistent with first-quarter levels of $10 billion to $11 billion per quarter resulting in full year origination growth of approximately 40 percent. HRB's mortgage-centric reliance on the subprime mortgage market will be its EPS albatross: tighter credit requirements and higher borrowing rates will lead to smaller interest rate spreads on loan originations, lower average gains on whole loan sales, and reduced net margins on its loan portfolio. To the extent that competitors will permit flexibility in pricing power--the ability to put margin costs back in the price of the loans--HRB's 'guidance' on FY '06 share-net of $1.90 is subject.
If management guides EPS lower, the bears on Wall Street will roar loudly that HRB should be revalued in-line with the likes of Accredited Home Lenders Co. (LEND), New Century Financial (NEW), and other publicly-traded mortgage lending companies. Repricing HRB with a forward P/E of 8.20 leads to a share-net valuation of $15.58. If you are shopping for losses for your 2006 tax return, buying HRB common stock might just give you those write-offs!

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