Friday, March 24, 2006

Unloved if not hated-H&R Block

Unloved if not hated, disparaged if not ridiculed. Large earnings misses, legal difficulties, getting its own taxes wrong. H&R Block (HRB) has been beset by everything but locusts in the last year.

Is there any value here?

Well let’s go through the litany of issues:

1) Eliot Spitzer- On March 15th, the NY AG sued HRB for alleged fraudulent marketing of a money-market linked account called the Express IRA. The suit claims that HRB clients were guided into an account which was fee heavy and generated little interest, consequently customers were almost certain to lose money. An interesting editorial in today’s WSJ defends and supports the H&R Block position on this disputed product:

Here is the op-ed piece of Mark Ernst, the CEO of H&R Block to which the above post refers:

2) Disappointing Volume of Returns-Interim tax season return volumes (to Feb 28th) are down about 4% at owned and franchised offices. However, digital solutions volume (H&R Block’s own Do It Yourself tax software) is up about 14%

3) Mortgage Volume Down- Mortgage Operations revenues represented about 25% of total revenues in the most recent quarter. This is down from peak levels of just over 30% a year ago. Pre-tax margins on mortgage services had run at 57% two years ago…currently, would you believe 16%!!!

4) Investment Services Still Running Losses- Olde, which is the core around which this business was built, was purchased in 2000 (timing??) The business saw a profit of $9 million on $366 million in revenues back in Fiscal 2001. Pretty much red ink since then and last year down to $240 million in revenues.

5) Business Services- This is payroll services to small businesses. Starting to grow nicely but margins are in the 5% area.

6) Managed to mess up its own taxes on matters relating to the Olde acquisition.

What has gone right?

1) Pricing on tax returns has been up about 6% YOY. This could actually expand as tax season draws to a close since more complex, and consequently more lucrative returns tend to be done later in the tax season.

2) TaxCut software receives very favorable reviews compared to other tax software.

3) Tax simplification ain’t happening, not now, not soon.

4) Dominant position in tax services in the U.S. The company processes about 16% of all personal tax returns filed representing about 19 million clients.

4) H&R Block has received approval for a bank charter. HRB has 12,000 potential locations for full service financial services. This provides HRB another opportunity to offer early refund loans at favorable spreads.

5) The company enjoys incredible profitability based largely on its dominant position in tax services. Every diversification in which it has engaged brings lower returns on capital if not losses. But despite this “de-worsification” the aggregate company continues to have tremendous profitability:

Year.....ROIC.....FCF ($ millions)......Fully Diluted Shares Outstanding(millions)

EV/EBIT is currently 10 times. The company is trading on a forward P/E of only 12.5 times trailing EBIT. Contrast this with Jackson Hewitt(JTX) with an EV/EBIT of 13.3 times trailing EBIT and a forward P/E of 19.3 times. For JTX, its ROIC is also considerably lower at only 10.2% for the TTM.

Though I am not quite ready to step up to the plate on HRB, given today's strength, I do find it quite intriguing. Despite the litany of problems, the company continues to enjoy a dominant position in its primary business. The potential for a national bank charter serving the "under-banked" has been ignored by the market in my opinion. Hopefully, lower prices will present an opportunity.

Disclaimer, I, my family, and clients do not currently maintain a position in either HRB, or JTX.

Have a great weekend!


At 9:35 PM, Anonymous Anonymous said...

Generally speaking, my experience has been that when a company makes the mass market media as incompetent, poorly run and destine for future failure, or as great, unchallengeable and spectacular; you’re generally well rewarded taking the other side of that trade.


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