H&R Block Inc. shares have dipped this week amid concerns over delinquent home loans to people with troubled credit histories.
Avalon Research Group sounded the alarm in a report advising investors to sell the stock. "Subprime lending lies at the heart of H&R's stellar growth in mortgage operations," but its speedy growth in subprime lending could backfire if customers cannot repay, the boutique research firm said.
Mortgage operations accounted for 47.3% of the company's pretax earnings in its fiscal 2002, which ended April 30.
"The company currently exhibits high delinquency rates, which we believe will deteriorate further as the economy constricts," Avalon said.
Shares of H&R Block closed up 3% on Thursday, at $38.57, but the stock was trading above $50 a share just a month ago.
"We believe the Street has been overly generous with the multiple granted H&R Block," said Avalon, which predicted that the stock could dip as low as $15. That would reflect less gain on loan sales, due to rising interest rates; such gains accounted for 63.7% of consolidated earnings in fiscal 2002, Avalon said.
Bob Schneider, a spokesman for H&R Block, disagreed with the analysts, saying its mortgage and tax businesses remain strong. He added that the company is still comfortable with its fiscal-2003 earnings projection of $2.80 to $3 a share, which it raised from $2.60 to $2.75 in late August.
Bill O'Neill, the chief financial officer of H&R's Option One Mortgage unit, said he does not see loan sales weakening. "The pricing we are getting [in securitization] is among the best in the industry," he said. "We're selling more home loans, and Wall Street firms are buying them," as they would not if they thought the value would drop.
Mr. O'Neill acknowledged that H&R Block expects higher loan losses. The Kansas City, Mo., company estimates that they will reach 4.85% - 20% higher than the worst year, 1995, when they were about 4%.
"Because the economy has been a bit soft the past 18 months, we've built in a higher loss estimate," Mr. O'Neill said. "We look at historical losses and want to build some kind of cushion into that."
So far, though, he said, losses have been lower than anticipated. The delinquency rate for subprime loans is 7.5% to 7.75% of H&R Block's roughly $20 billion portfolio, Mr. O'Neill said. Customers must miss at least two payments before their loans are considered delinquent.
Because of securitization, H&R Block retains the risk on "maybe" three-quarters of the loans, Mr. O'Neill said. At the end of July it had about $400 million in residuals, the portion of a securitization it keeps on its books.
A softening housing market and higher interest rates should not hurt the subprime loan business, Mr. O'Neill said. "Our borrower isn't driven so much by our interest rates; they've got a need for cash," he said. "The subprime guy doesn't have cash. Home is access to liquidity."
About 60% of H&R's Block's mortgage business comes from equity loans, roughly 33% from purchase loans, and about 7% from refinancing loans, Mr. O'Neill said.
