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HRB earning and ADGO

08/31/2004

HRB quarter earning

Unexpected larger negative earning mainly due to Mortgage business

H&R Block reported 2005 fiscal year Q1 earning last week. HRB stock price sold off afterward due to the "unexpected" larger loss. The unexpected loss is mainly due to poor performance of HRB mortgage business division.

However, My take is that HRB earning was pretty good considering the low valuation of current HRB stock price.  The Q1 lower mortgage earning is also in line with management expectation. HRB management still forsee a flat or slightly down mortgage division net earnings.

HRB mortgage business explanation

The HRB mortgage business in 05 Q1 encountered sharp decrease of profit margin due to interest rate sudden rise.  Here is my simplified version of explanation for typical HRB mortgage transaction:

1. HRB borrows money from open market source (bank, etc) and lend out the money at higher interest rate to its mortgage customers.
   
2. HRB charges its mortgage customer at 7% interest rate for the loan.
   
3. HRB borrows money from banks at 3% interest.  1% of loan is additional overhead cost HRB incurred for the loan.
   
4. HRB make Net Profit at 7% - 3% - 1%  =  3%  of mortgage loan size.
   

3% is typical HRB profit margin (called Net Margin by HRB management). During Q1,  Interest rate suddenly rose 1% in a few days so that HRB had to borrow at 4% cost instead of 3%.  However, due to business relationship between HRB and mortgage brokers, HRB could not increase mortgage rate immediately. HRB mortgage pricing lag for 1 - 2 quarters.

Now look at new Net margin: 
HRB Net Profit  7% - 4% -1% = 2%.

Instead of making 3% of mortgage loan size as profit, HRB mortgage profit is only 2% of mortgage loan size.  That is profit decrease of 33%.

HRB mortgage profit decrease is one time issue

HRB way of mortgage business practice will cause the mortgage profit unpredictable quarter over quarter.  During sharp rise of interest rate, HRB will incur significantly less profit; During sharp drop of interest rate, HRB will incur significantly larger profit because HRB will not drop their mortgage pricing as quickly too.

From long term investor point of view, this type of up or down quarter over quarter of mortgage profit is no big deal. Over the time, this zig zag of earning will even out. HRB mortgage business profit margin is expected to go back to normal level of 3% later this year.

Furthermore, origination of mortgage is actually growing year over year at double digit rate. HRB is shifting mortgage business into more profitable  non-prime mortgage as well.  Non-prime mortgage business is mainly for those low-income or poor credit clients. Non-prime mortgage business is less sensitive to higher interest rate expected down the road.

HRB - low PE high free cash flow

HRB has very little capital expenditure. Almost all the earning is free cashflow.  WIth PE at 13, I continue to like HRB.

ADGO - Adams Golf

ADGO - under-priced

ADGO reported excellent earning recently.  Adams Golf business has been doing very well in 2003 and 2004. However, the stock price of ADGO was trading at around $1.00 recently below its book value and liquidation value. Here is comparison of ADGO to Aldila(ALDA) and Callaway (ELY) as of 08/26/2004:

	ELY	ADGO	ALDA
Mkt cap	816 M	24 M	58M
PE	36.7	9	84.9
Price / Book	1.3	0.89	2.1
Price / sale	0.85	0.44	1.34
Enterprise Value / EBITDA	9.57	3.56	12.75

ALDA is golf club parts manufacturer. ELY is largest golf club manufacturer.  Clearly the above table shows that ADGO is trading at half or less of value of ALDA or ELY.

ADGO prospect -  new product release in Nov

Based on recent conversation that I had with ADGO management,  Adams Golf will release new product Redline2 driver and Redline 2 Fairways in November of 2004 and GT2 version of iron product line in early 2005.  Redline product lines are relatively high-end product line while GT product line is relatively low-end of product line.

Ovation Fairways has seen increasing sales and profit since  Adams Golf released it early this year. I expect that the new product lines will continue to drive ADGO revenue and profit in 2005.

ADGO - potential re-listing

The ADGO management assured me that the management has no intention to delist the stock. The ADGO management has been studying re-listing issues actively recently.

ADGO has enjoyed pretty good profitability so that it potentially can re-list the stock to NASDAQ smallcap market. The requirement for re-listing is $5 minimum stock price and $20,000 re-listing fee. The cost is insignificant compared to its profitability by my calculation. A reverse split of 5-1 or 10-1 will put ADGO stock price above $5 to meet the requirement.

Conclusion

Considering the low valuation of ADGO and potential positive new product release or NASDAQ relisting, I continue to like ADGO stock.

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