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Over-taxed and under-appreciated
SNL Financial (May 5, 2003)

Maybe first impressions should not matter.

One of the most recent additions to SNL Financial's coverage universe, H&R Block Inc., posted one of the industry's worst returns in a month where most stocks bounced off floors in a post-war rally. Though the company pulls well over a third of its earnings from a budding mortgage-banking business, the market apparently - and erroneously - relegates it to a class of its own.

The Kansas City, MO-based company, which prepares tax returns, as well as offers consumer loans and mortgages, was the worst-performing stock among residential mortgage bankers, posting a loss in April of 12%, while its mortgage-focused peers saw a median gain of 13.77%. In fact, it posted the fifth-worst return among all 144 SNL-covered financial services stocks listed on the primary exchanges.

The stock's losses stemmed from a series of disappointing reports related to its tax preparation business, which in turn spurred two analyst downgrades. On April 2, the company reported that it had prepared 11.7 million tax returns over the first 10 weeks of 2003, down a total 2.9% from year-prior numbers. Even though the company reaffirmed its fiscal-year 2003 earnings guidance of $3.10 to $3.25 per share, on April 3, Goldman Sachs downgraded the stock and the market sold it down nearly 10% to $40.03 per share.

The scenario was repeated April 15. The company reported that volume had not significantly risen through the second half of March and that the company would not meet its client-growth target. The next day, the company opened down 6.9%, but following a midday news release stating a judge had rejected H&R's proposed settlement regarding its allegedly abusive tax-refund-loan rates, the company closed down 8.7% to $37.98 per share, or just 11x expected 2003 earnings.

On April 29, Morgan Stanley downgraded H&R to "equal-weight," citing reduced expectations for tax-segment revenue growth. By April 30, when the company reported that preparations as of Tax Day were still soft, the market appeared to have already adjusted to lower expectations of the company. Tax returns, H&R said, were down 3.4% year-over-year, though tax-related fees were up 3.2%. On May 1, the HRB stock fell just 2.4% to $37.70 per share.

The market certainly understands that H&R Block is chiefly a tax preparation firm. For H&R's fiscal year-ended April 30, 2002, 55% of its revenues and about 62% of its earnings before interest, taxes, depreciation and amortization came from its U.S. tax operations. That's an important chunk of change. But what about that other 45% of revenues and 38% of earnings? Are investors ignoring another significant, up-and-coming driver of H&R earnings?

It's looking like it. Since H&R bought Option One Mortgage Corp. in 1997, the company's income statements have been buoyed by sharp rises in its mortgage banking business. In 2002, mortgage operations reported $354.1 million, or 37.2%, of H&R's income on a continuing EBITDA basis. That more than doubled 2001's total, $160.8 million, and dwarfed the previous three years' numbers, ranging from $43.5 million to $108.9 million.

The mortgage banking growth throughout H&R's fiscal year 2003 - which ended last Wednesday - should be equally impressive. Over the past three reported quarters, H&R already has logged pretax earnings on its mortgage operations of $563.1 million, versus the $237.4 million recorded during corresponding year-prior quarters.

That earnings growth for the most part was found in non-prime markets. According to the company's most recent Form 10-K, H&R's mortgage segment "offers a flexible product line to borrowers who are creditworthy but do not meet traditional underwriting criteria." And as of its third quarter, the company's average FICO score for non-prime originations was 606, compared to 604 in the second quarter and 597 in the year-prior quarter.

That focus on the non-prime market, however, could be a good thing. Whereas industry leaders such as the Mortgage Bankers Association of America are predicting demand for conforming loans to dry up in the second half of 2003, the nonconforming, subprime mortgage market is more widely seen as already underserved.

Irvine, CA-based New Century Financial Corp. - and some of its investors - certainly think so. The pure-play subprime mortgage originator (average FICO score: 598) saw record earnings and nearly doubling loan production in its March quarter. As such, management boosted its 2003 earnings guidance, "anticipating that favorable industry conditions will continue." Since its April 17 earnings report, New Century's stock has gained 17.5% to begin trading at record highs. Those record highs still aren't very high - they may well have room to grow. At $39.49 per share, NCEN shares go for about 5x its 2003 guidance - a valuation that reflects today's emotionally taxed trading environment. Sell-side analysts' average price target on New Century implies a 6x earnings valuation. While even a bearish hedge fund, Wall Street Consulting Group Inc., has said the stock could hit close to 6.5x. New Century's CEO, perhaps unsurprisingly, has told SNL that the company is capable of 8x to 10x earnings.

Unfortunately, the 5x-mentality currently reigns in subprime mortgage financing. Five times is right where analyst Chris Gutek of Morgan Stanley prices H&R mortgage segment. And it's in the 4x-to-7x valuation range Goldman Sachs' Michael Hodes assumes for H&R's Mortgage Operations. Smith Barney's Michael Millman doesn't even factor in H&R's mortgage ops: "We have eliminated Option One, Block's subprime mortgage business, from our valuation because of market concerns about the volatility of the business," he wrote on April 30.

That's an unfortunate attitude. Tax preparation may always be the heart of H&R Block, but mortgage banking is increasingly giving it legs. As the subprime mortgage-banking sector continues to prove itself, investors of H&R may find their company sitting on a surprisingly valuable, secondary business.



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