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MagicDiligence (< 20)

The Returns Have Already Been Filed on H&R Block



April 08, 2011 – Comments (0) | RELATED TICKERS: HRB , INTU

H&R Block (HRB) is by far the largest provider of tax preparation and other financial and business services in the United States. The company's biggest and oldest business is Tax Services, which generates 77% of revenues and over 90% of operating profits. Block has 12,000 offices across the country, of which about 1/3rd are run by franchisees. These offices processed over 23 million tax returns in 2010, 15.5% of all returns filed. To put Block's dominance in perspective, second place Jackson-Hewitt (JTX) processed about 2.5 million - about 1/10th of HRB.

Although Block's bread-and-butter is office prepared returns, the company has aggressively moved into the "do-it-yourself" (DIY) software-based return preparation market in the past year. While H&R produces its own software product, it made a big move last October with its purchase of TaxACT, which doubled DIY sales. This now puts Block solidly at #2 in tax software, but still only at about half the market share of Intuit's (INTU) TurboTax products

In addition to tax services, the company has a Business Services unit known as RSM McGladrey. This group provides accounting and tax consulting services to medium-sized businesses. RSM produces about 22% of revenue and 10% of operating profits.

Finally, H&R Block Bank is a small banking operation primarily structured to provide advances to tax customers. The company got itself into hot water originating subprime mortgages in the middle of last decade, but this business was shuttered in 2008. Still, there are almost $600 million in mortgage loans on the balance sheet, held for investment (but serviced by other firms).

There are clearly some attractive points about HRB. Tax preparation has historically been a good business. It has recurring revenues, is largely recession-proof, and requires little in the way of capital investment. These factors lead to high operating margins (Block's historical average is in the 15-20% range) and voluminous free cash flows. In this particular case, H&R Block possesses easily the best known and trusted brand in the business, which helps to foster customer loyalty and also allows the company to maintain higher rates than competitors. In fact, Block has been able to increase its rates 4-5% annually since 2002 (although this is a waning phenomenon).

H&R Block also may pique the interest of dividend-focused investors. The current yield is a nice 3.6%, and the payout ratio is a very reasonable 40% of net income. With management re-focusing strictly on the tax prep business instead of ill-advised projects like subprime loans, there should be plenty of free cash available for the dividend to grow.

The final positive is momentum. 2010 was a poor year for the firm, with changes at CEO and CFO, the loss of refund anticipation loan (RAL) funding, and total returns falling 4%, with higher-priced retail branch filings down 6%. So far in 2011, though, the metrics are improving. Through the first half of tax season, returns filed at branch offices were up 2.6%, and DIY filings up over 13%. This is especially impressive considering Block is unable to offer RALs anymore. The dramatic problems at Jackson-Hewitt (which could be nearing bankruptcy) have helped, as has new initiatives like filing 1040-EZ forms for free.

Despite these positives, there are still reasons to be wary of investment. Block's software offering growth has lagged badly against TurboTax in the past. Software is a much lower revenue contributor, bringing down revenue-per-filing rates. Further hurting these rates are increased office-based competition, both from small chains like Liberty Tax Service and from "pop-up" operators and accountants nationwide, which drastically undercut Block's fees. In the long run, this is a market share industry - there's not much organic growth. Add to this the fact that the market size opportunity will decline for the foreseeable future and there is not too much to be excited about.

2011 and possibly 2012 look decent for this company, as market share stabilizes and the effects of cost cuts take hold. But given the poor long-term picture, I highly doubt that Wall Street gives back the 6-7% earnings yield the stock used to enjoy. My fair value for HRB is $19, which is only about 12% of upside given the stock's current run. That's not enough to recommend it. Most of the returns have already been filed on this stock. MagicDiligence is putting the "neutral" rating on it. You can do better elsewhere.

Steve owns no position in any stocks discussed in this article.


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