H&R Block (NYSE:HRB) has decided end its seedy subprime mortgage affair and go back to its true love, preparing taxes. Unfortunately, the tryst has already left the company with a lingering case of subprime contagion.

The company is moving to limit its subprime exposure and has already shut down its subprime mortgage wing, Option One. H&R Block's efforts have begun to work, as is proved by its narrowed losses in its latest quarter reported late Wednesday, but these are the first steps in what will be a long recovery. Compounding the problem is simple truth that the tax preparation business could suffer as all three presidential candidates want to simplify the tax code.

So Many Answered the Siren's Song
When you hear H&R Block, you generally think of taxes, but like many others, the company was seduced into the risky world of subprime mortgages and ultimately suffered. For its fiscal third quarter, the company reported loss of $47.4 million (14 cents per share) compared with a loss of $60.3 million (18 cents per share) a year ago. Overall revenue rose 4.3% to $972.6 million, coming in below analyst expectations of $1 billion.

The company's losses were largely due to shutting down its Option One origination platform. This was H&R Block's platform to originate subprime mortgages, and, needless to say, it has caused the company some headaches. (To learn about another subprime victim, see Fatal Seduction of The Municipal Bond Insurers.)

Option One is now carried as discontinued operations. Earnings from continuing operations came in at $9.3 million (3 cents per share) compared to $21.9 million (7 cents per share) one year earlier. Not counting other charges for staff reductions and executive departures, the company would have $25 million (8 cents per share) coming in ahead of the 6-cent-per-share consensus estimates. Shares were up nearly 4% on the news.

On the company's conference call, management repeatedly discussed the steps being taken to get out of the mess. Before it can return to a sustained culture of increasing shareholder value, it needs to deal with Option One. The company has made significant progress in this area by reducing total loans held both on and off balance sheet from Option One to $21.9 million. Despite the progress, it is not over yet. The company is trying to sell the business, and this could continue to be a drag. Another move from H&R Block is just to stop moving with some of its mortgage exposure. Management noted that its mortgage exposure will decrease substantially over the next few years as it just lets them mature. (For related reading, check out Off-Balance-Sheet Entities: The Good, The Bad And The Ugly.)

Taxing Times in Tax Prep
Revenues from tax services rose 5.4% for the quarter to $661.8 million from $627.8, the year before. This is the good news. The bad news is there is increasing competition in the tax preparation arena and new, simpler rules could hurt everyone in this field.

H&R Block's strategy is now to push for more penetration in the market of competitors like Jackson Hewitt (NYSE:JTX) and Intuit (Nasdaq:INTU). Jackson Hewitt reported declines in revenue and a 34% drop in profit. H&R Block is also looking to refocus its banking arm on customer services utilizing its tax client base. The company steered clear from this in recent years, instead focusing on its risky Option One platform. The company may even decide in the next few years to sell off its bank and focus solely on tax services, through partnerships with banks.

The tax preparers also have problems in the presidential candidates. All three candidates have pledged to simplify the tax codes, which could mean less business. No matter what, H&R Block will remain bogged down by this transition a little longer, and even management has admitted that this is the first step necessary before H&R Block can return to creating shareholder value.

The Bottom Line
H&R Block announced results that were decent in the face of their previous troubles. The company is still working to fully remove its subprime business, and this will remain a drag on its progress. Shares of H&R Block popped after the news, but I would recommend staying away from the tax service providers for now. There is just too much that can drag them down.

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