The Wall Street Journal-20080212-H-R Block May Be Primed to Rise- Costly Mortgage Foray Ending Under Breeden Focus on Core Business

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H&R Block May Be Primed to Rise; Costly Mortgage Foray Ending Under Breeden Focus on Core Business

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Taxes may be one of life's certainties, but the past year has been anything but certain for tax preparer H&R Block Inc.

As a result of a foray in the mortgage business, the firm's stock is down nearly 21% in the past year and off almost 40% since its peak in 2004. In 4 p.m. composite trading yesterday on the New York Stock Exchange, Block's shares were up one cent to $18.76.

But some analysts and investors now believe that the Kansas City, Mo., firm is on a path to recovery. They are counting on the firm's new chairman, Richard Breeden, who assumed his post in November, to follow through on his pledge to focus on Block's core tax business.

He seems to be making good on that vow. About a month after taking over, the former head of the Securities and Exchange Commission has shuttered Block's Option One Mortgage Corp. unit -- the source of big losses in recent years. In anticipation of the closure, Block reduced Option One's $3 billion of mortgage exposure to $113 million as of Oct. 31.

"We've capped the well," Mr. Breeden says. "The losses are essentially done."

The tax business has been the primary driver of earnings for the firm, contributing two-thirds of revenue and most of its profit for the fiscal year ended April 30, 2007. Still, Block posted a loss of $1.34 a share, due primarily to shortfalls at the mortgage unit, which was facing higher defaults on mainly subprime loans.

There are still about $1 billion of mortgage securities held by the H&R Block Bank unit. But Mr. Breeden says these are considered "prime." Block is holding them as investments and currently has no plans to sell them.

Block says it expects continuing operations to post earnings of around $1.30 a share from for the fiscal year ending April 2008, up 12% from $1.16 a share reported last year. Part of that will come from an increase in tax-preparation fees that the firm imposed this year. According to Block, the $1.30-per-share guidance takes into account higher borrowing costs for this fiscal year.

All this will allow investors to focus on the firm's earnings from continuing operations, which excludes Option One, because "the part that's draining money is going away," says Todd Young, a stock analyst at Morningstar Inc. who rates Block's shares a "buy."

The stock is trading at a 13.4 times forward price-to-earnings ratio, according to Thomson Financial. Four analysts polled by Thomson have a mean target stock price of around $23.25 a share.

Still, significant challenges remain. For one, the firm may face regulatory action from the Office of Thrift Supervision, which regulates HRB Bank, for its expected failure to meet a specific capital-ratio requirement by April 2008, as it had previously anticipated. Mr. Breeden says the OTS had imposed the rule -- requiring Block to meet a 3% minimum ratio of adjusted tangible capital to adjusted total assets -- in light of potential risks to the firm because of its mortgage business. HRB Bank is termed "well capitalized," the highest level of capitalization, according to regulators.

Mr. Breeden says the board will decide the fate of the bank in the next few months.

Another issue is Block's higher debt, which in part prompted Fitch Ratings to reduce its credit rating by one notch to triple-B. Amid the credit crunch last year, the company had to draw upon $1.8 billion of unsecured credit facilities to meet its short-term capital needs. It expects to repay a bulk of this with the cash generated this tax season. It also has $1 billion of medium-term debt.

Meanwhile, like other tax preparers, Block also faces some uncertainties on the regulatory front, such as a possible crackdown on loans on anticipated refunds.

Investors are optimistic. "The company is finally getting back to what it should be doing," says Tim Fidler, a money manager at Ariel Capital Management. Since a slowdown in the economy doesn't affect the filing of tax returns, "historically speaking, this stock does well in recession and midcycle slowdowns," says David Giroux, manager of T. Rowe Price Capital Appreciation Fund, which owns the stock.

Mr. Breeden says Block plans to expand the tax business by doing more complex tax forms and increase its presence in electronic software. "We want to be the Microsoft of taxes," he says.