H&R Block's in Big Trouble Heading Into Tonight's Earnings

Cerberus backed out of buying Option One Mortgage from H&R Block. Now what?

This entire year HRB investors have been looking at an deal with Cerberus as a way out of the subprime mess. Yet now that this deal has collapsed, the news was almost portrayed as a mutual positive for both companies?

Imagine what would have happened if the deal actually happened!

The truth of the matter is that H&R Block is in trouble. And the only way out is to come clean on their full exposure to subprime and write down as much as possible right now, before they move forward and focus on their core tax services business.

With the pending CEO search I expect the company to write down billions prior to a new CEO assignment. It's only common sense. If you were approached to take the top job and knew the company originated 40B in subprime loans in 2006 and 20B in 2007 and has yet to write down any of it, would you take the job and add those write downs to your executive resume?

1+1 doesn't = 2 at HRB.

A) Board Member Choate resigns from HRB citing health problems, yet still services on AMGN and Valero? Hm?

B) HRB announces 181st consecutive quarterly dividend Nov 28, 2007, but then taps its credit line for 6th time for a total of $1.8B in liabilities. Borrow to insure solvency, buy time and not cut the dividend? Hm?

C) HRB CFO, Trubeck resigns Nov 5th, 2007.

D) Moody's places review of HRB for downgrade Nov 13, 2007 , specifically the senior debt and short-term ratings of Block Financial Corp.

E) H&R Block announced Nov 21, 2007 that Chief Executive Mark A. Ernst resigned amid bleak prospects to offload the company's money-losing subprime-mortgage unit.

F) Fitch lowered Block's issuer default rating one notch to "BBB," the second lowest investment grade, from "BBB-plus."

G) Option One remains in trouble. Just because HRB declares they are closing Option One and its originating activities, doesn't mean the 40B+ in orginations in subprime vanish into thin air. At some point they will have to mark down tremendously and sell or write down tremendous amounts! Without a doubt, Option One and HRB have been a major player in the subprime origination business the past few years. They were ranked #3 in Q3 2007, #4 in Q2 2007. And if you look at their company on this list they include Countrywide, Delta Funding, Citi, EMC Mortgage, HSBC, Wells Fargo, and Wamu.

H) You would think that a company who is trying to keep delinquencies to a minimum would help mortgage borrowers pay on time and offer great customer service right? Wrong! Check out some of these compaints to Consumer Affairs. Ask any mortgage office you know or sold you your mortgage about Option One. They were always the last resort, when their clients couldn't get approved by other prime lenders and even Country Wide!

I) According to this author on Seeking Alpha, On Nov 12th, someone bought a a 28,000-lot transaction in the January 20 puts for HRB, which is 74% of open interest in one trade! That buyer suspects or knows something!

J) Finally the downtrend of HRB is proven in this chart and the P&F target is $12. Yet the stock is up since the news of Cerberus walking away from the Option One deal. HM? Also note that Institutions own and control 95% of HRB's float with only 2% insider ownership.

In summary HRB will have to really pull out 12 rabbits out of their hat on their next 10Q Monday Dec 10th. I only see limited upside and a high potential for severe selling pressure with heavy institutional ownership. Once Moody's comes around with a potential downgrade and more writedowns likely, the large funds and institutions holding HRB will surely sell. And mom and pop will not have enough capital to slow down the precipitous drop in share price I expect in a short time.

HRB reports earnings after the close Monday Dec 10 and will host their conference call Tuesday 8am.

Disclosure: Author owns long-term HRB puts.

Comments

[Neitherbull norbear]

nice job, their Q stinks!!!!

[SilverDollar]

I don't buy the this spin on HRB. But we will see. Are we to buy the story that mortgages were lent on swamp land? What are the property valuations behind the mortgages. If we are to believe this then the US is going into the greater Depression of 2008. Maybe HRB should just get into the rental and ownership business. Banks made a fortune in the depression years taking up foreclosed properties. But then again some agents write these depressing articles.

[NYUGrad_Matt]

To follow up on my initial research, HRB canceled their earnings release the day AFTER it was due. Canceled their earnings conf call the morning of the call. Pre announced prior to official 10Q 502M loss for qtr. Postpone the conf call indefinitely until further notice. And confirmed the losses this morning with additional details of their plan to either try to raise more money because they have maxed out, or dilute shareholders and sell more shares.

This summary from CNN about wraps it up:

Excerpt:
In the SEC filing, H&R Block said it does not expect to be in compliance with requirements set by the Office of Thrift Supervision by April 30. "If we are not in a position to cure deficiencies and if operating results continue to be below our plan, a resulting failure could impair our ability to repurchase shares of our common stock, acquire businesses or pay dividends."

If the company does not meet OTS requirements, the agency could take further regulatory actions, such as a supervisory agreement, cease-and-desist orders and civil monetary penalties. The OTS could also require H&R Block to sell assets. "At this time, the financial impact, if any, of additional regulatory actions cannot be determined," the company said.
tinyurl.com/2ddpwo

[Brian Harper]

Matt, What do you attribute the potential billions in additional losses to? The company has only $70 million in remaining loans on its books related to the discontinued OOMC operations. The net book value of discontinued ops is $860 million, $965 million of assets and liabilities are offsetting and have no economic value or risk and will ultimately roll off. Essentially the remaining value of OOMC is related to the servicing ops, which are valued at $820 million as of the 10-Q. Do you have an idea of what might be written off or what might be reserved against given the companies remaining assets and exposures?

Don't forget that HR Block's business is seasonal and they always build up debt at this time of year, then they generate all of their earnings and cash flow between now and April and the debt is paid down. The difference this year is that they've had to tap a credit line rather than their normal issuance of comm'l paper since the comm'l paper market has dried up.

[NYUGrad_Matt]

Bryan,

I don't believe them! It's that simpl! HRB has already restated earnings for last 3 yrs. They are not a transparent company. They were also the ones tauting Cerberus would buy OOMC since the beginning of 2007. That is a fact.

They were a top 5 subprime lender. Everyone including Citi, Wamu, CFC, couldnt get .90 for the $1 when selling their subprime. And OOMC's subprime is the gutter variety. with credit score 611 and under. And horrible collections tactics.

You prob have no idea so i wont ask you, rather I will ask HRB on the conference call... Where are the 26B in subprime originated since last yr? How much did you sell them for if sold and how much? If they haven't sold what do they plan to do?
tinyurl.com/2alycc

Add those quarters up and you get 27.6B in originations.

Thank you for your comments.

[NYUGrad_Matt]

Bryan,

Case in point on horrific quality of their subprime:
Delinquency rate 2007 = 17.89%
Delinquency rate 2006 = 8%
tinyurl.com/3yylor

Page 45 of HRB 10Q.

Do you truly believe they were able to sell these for 90 cents on the dollar to Freddie and Fannie? Or to ANYONE!?

[Brian Harper]

They stopped originating all but fannie/freddie loans in August. All the loans they ever originated have been securitized-the company retains no liability but $113 million of loans remaining for sale. The odds that they could have lied about this are exactly nil.

The page you are referring to in the Q is a reference to the servicing business. Servicing doesn't retain credit risk. Servicing businesses still have value in this market-they are low risk and relatively predictable cash cows. It will ultimately get sold.

Breeden has no reason to lie, he bought into the co after all this stuff went down. His money is where his mouth is.

Fair value: $27-28/shr.