H&R Block Taxes Investor Patience

The group's struggling mortgage business has led to a hefty quarterly loss, a stock price near a 52-week low, and plenty of skeptics

H&R Block's (HRB) earnings famously come in the months before April 15, but it looks to be a taxing year for the company and its investors. In recent months it has taken hits from all fronts.

Although the tax and financial services group's shares haven't quite reached a 52-week low—in March they dipped below $20 briefly when New York Attorney General Eliot Spitzer filed a lawsuit against the company—the stock remains in purgatory. Despite recent falls, analysts are skeptical of its upside potential. While it pays a reliable dividend, value investors may want to look for better bets elsewhere.

On Aug. 31, Block posted a quarterly net loss of $131.4 million, more than four times the loss for the same period in 2005 and worse than Wall Street expectations. Most of the drop was owed to poor performance in the mortgage services business, where defaults were higher than expected.


  During an earnings conference call on Aug. 31, CEO Mark Ernst said "this is not a situation where misery loves company," pointing to units such as tax services where the company had met its expectations. Even so, there are several reasons to remain wary.

The stock's most recent shock came a week before the earnings report when the company said it would record a provision for losses of $102.1 million due to the poor conditions of its nonprime mortgage business. These mortgages, issued to customers with bad credit, limited income, or other financial problems, make up the bulk of Block's mortgages. The warning sent Block's stock reeling: It lost 8.7% on Aug. 25 to close at $20.81.

In the wake of the announcement, UBS (UBS; a market maker for H&R Block shares) downgraded the company from buy to neutral. Standard & Poor's analyst Loran Braverman lowered her rating to sell.


  Braverman says conditions could decline further in the nonprime mortgages sector. "We're starting to see more concerns" about people's ability to pay. "In a weakening economy, one would expect that people with the lowest income and weakest credit would be affected," says Braverman.

Months from tax season, and the company's primary earnings months the company is too dependent on mortgages to be seen as a value play, she says. Sure, it pays a nice 2.6% dividend, but since the stock could drop further, the analyst thinks investors would do better with a money-market account paying out 4.5%.

Despite its mortgage problems, H&R Block remains the U.S. market leader in tax services. But it's not untouchable there either. In a recent report, Morningstar analyst Kristan Rowland points out that tax client growth has been lackluster of late.

"Block's volume of tax returns has generally stagnated as a result of competition" from mom-and-pop accountants as well as up-and-comers like Jackson Hewitt (JTX) and Liberty Tax. Morningstar also points out that Block must compete against a growing number of technological options like free online filing and tax software from Intuit (INTU) (see BusinessWeek.com, 3/21/06, "H&R Block's Daunting Bottom Line").


  Braverman, of S&P, seems slightly more optimistic about the tax business' prospects. With so many independent accountants, she says, there's still room to expand. And given the ever more complicated tax rules, "people don't necessarily feel confident" using software. But the customers could go to competitors like Jackson, which, she says, has shown "better execution" and is gaining in market share.

H&R Block's mortgage crisis comes on the back of earlier problems. Motions are to be argued this week in Attorney General Spitzer's lawsuit against the group. He sued the company for fraudulent marketing of retirement accounts called Express IRAs that his office says "were virtually guaranteed to lose money because of a combination of hidden fees and low interest rates." The company vigorously defends its practices.

The tax return preparer was also embarrassed when, just before tax day of this year, it filed a delayed quarterly report for the quarter ending in January and financial restatements for the fiscal year ending in April, 2005, and the two subsequent quarters. With so much bad news to digest, H&R Block is undoubtedly one of the few companies out there looking longingly toward next tax season.

Before it's here, it's on the Bloomberg Terminal.