Executive Summary

• H&R Block (“HRB”) is a stable, growing business with dominant market share that trades at a double digit FCF yield.
• Market share gain: Over the next few years, HRB should continue to grow its market share as independents exit the industry due to the elimination of refund anticipation loans (RALs) and the new IRS certification requirement which will take effect at year-end 2013.
• Good industry fundamentals: Tax returns will likely grow in excess of the historical average (1-2% growth) because Obamacare, which will be implemented in 2014, requires people to file a tax return to receive healthcare coverage.  Also, the upcoming fiscal cliff will likely increase uncertainty around the tax code causing more people to seek assistance from tax preparers like HRB.
• Solid capital allocation: HRB aggressively buys back stock ($340MM or 7% of current market cap over last 12 months) and has a healthy dividend (4.3% yield).
• More aggressive capital allocation or take-out: HRB hired Goldman this past October to pursue strategic alternatives with its bank subsidiary.  It will likely sell its bank this summer, which will allow the company to get more aggressive with buybacks since it won’t be regulated as a bank holding company by the Fed.  It could also open the door for a potential take-out.
• Substantially smaller mortgage putback overhang: In 2013, the Sand Canyon (mortgage putbacks) overhang will dissipate as the six year statute of limitations for putbacks is hit in many states.

Business Description

• HRB is the largest tax preparer in the world.  It has 12,000+ offices worldwide with ~100,000 tax professionals.
• In 2011, HRB prepared 22+ million tax returns in the United States and another 3+ million in Canada and Australia.
• In the U.S., HRB has a 18% market share in assisted, which is five times more than its closest competitor Jackson Hewitt.
• For more details about the business, I recommend going through the slide desk from their analyst day held last week (http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MTY0MjE2fENoaWxkSUQ9LTF8VHlwZT0z&t=1).

Thesis

• Stable, growing business with dominant market position.
• HRB has an 18% market share in the assisted market vs. its closest competitor at less than 5%.  It is a distant #2 in the digital market to Turbo Tax, but has been gaining share over the past few years.
• IRS tax returns have consistently grown 1-2% over the past 50-60 years.  Because of the implementation of Obamacare, which requires people to file a tax return to receive coverage, tax return growth will likely exceed the historic 1-2% growth near-term.  See slide 37 in HRB’s investor deck.
• Assisted share has remained stable at 60% for the past decade despite rumblings of digital taking share (digital growth has come entirely at the expense of pen and paper).  See slide 38 in HRB’s investor deck.  In addition, because of increased uncertainty around the fiscal cliff, there is a chance assisted takes share from DIY next year.

• HRB has stabilized its market share and has the potential to increase its market share over the next 2-3 years.
• Over the past five years, there has been significant mgmt turnover and uncertainty at HRB.  The new CEO joined just over one year ago and signed a contract for five years.  Since then, HRB has started to gain back share and focus its efforts on entirely tax instead of trying to be a one-stop financial shop.  Over the past couple years, HRB exited or is winding down Sand Canyon (mortgage originator), RSM McGladrey (business tax prep), and HRB Financial Advisors (broker/dealer).
• HRB was not able to offer refund anticipation loans (RALs) last year, but many in the industry were.  This year, no one has RALs because banks have exited the business.  Not only will the playing field be more equal this year, but some independents have already exited the tax business due to reduced profitability because of the lack of RALs.
• Forced professional certification – The IRS is requiring professionals in the industry to become certified by year-end 2013.  HRB pushed for this and most of their employees will easily pass, however, this certification will likely pressure independents and force them out of business or lower their throughput capacity.

• Cheap on an absolute basis and trading at the low-end of its historical range.
• Double digit FCF yield (10%).
• 5.0x forward EBITDA vs. its historical median of 6.8x.
• 5.5x forward EBIT vs. its historical median of 7.6x.

• Solid capital allocation with a strong commitment to return capital to shareholders.
• William Cobb during FY4Q12 earnings call: “Since I became CEO 13 months ago, we've returned $723 million to shareholders in the form of share repurchases and dividends.  Over that span we repurchased and retired 36 million shares at a total cost of $515 million or $14.38 per share, including 21.3 million shares since May 1 of this year.  This represents 12% of the shares that were outstanding at the end of fiscal 2011.  We also increased the annual dividend last December by 33% to $0.80 per share.  Altogether, I believe our actions demonstrate that we have a lot of confidence in our business and that our philosophy on capital allocation is shareholder-friendly.”
• Low likelihood of bad M&A because there is nothing to buy.  Returning capital to shareholders is really the only option.

• Bank divestiture will lead to more aggressive capital allocation.
• HRB is currently regulated as a bank holding company by the Fed, which restricts its ability to aggressively buyback stock and lever up.  As a result, HRB has hired Goldman to sell or wind down its bank subsidiary.
• Based on a historical analysis of the capital structure, the company is underlevered and could take on debt to buyback stock (I recommend graphing HRB’s net debt over the past 10 years).  Also, during its recent investor day, mgmt mentioned how it no longer needs to maintain its investment grade rating to access the commercial paper market to deal with cash flow seasonality.  Instead, HRB can use its new $1.5B credit facility, which it entered into at the end of August.
• Selling the bank also opens the company up to a potential sale (http://www.bloomberg.com/news/2012-10-19/h-r-block-seen-inviting-buyout-by-removing-bank-real-m-a.html).
• The next Auto Zone?  Apparently mgmt has studied Auto Zone as a case study for what can happen to your stock price when you shrink the share count aggressively and consistently grow EBIT.  Maybe this is why they moved so quickly to sell the bank when they found out the Fed would restrict leverage/buybacks.

• Sand Canyon overhang will continue to lift in 2013.
• HRB shutdown this division in 2007 meaning that the six year statute of limitations for putbacks will be hit in 2013 for many states.  This means that putbacks will likely be zero or close to zero in the future.  Putbacks have already slowed materially.  This past quarter, HRB had $10MM of putbacks, which compares to over $500MM just two quarters ago.
• As time passes, putbacks should naturally decline because it becomes harder to argue that there was a flaw in the origination process if the loan does not default within the first 1-2 years.  HRB originated its last loan in 2007 so it has already been 5-6 years.

• Increased sell-side coverage and investor interest.
• Given the size of its market cap, HRB has surprisingly little sell-side coverage.  Morgan Stanley is the only bulge bracket bank that covers the name.  Other firms that cover HRB include Oppenheimer, Compass Point, and BTIG.
• I suspect that HRB’s lack of coverage is due to its historical complication (Sand Canyon, various lines of businesses, and bank subsidiary).  Many, if not all, of these complications will substantially go away in 2013 which could lead to additional sell-side coverage.

• In the event of massive putbacks, HRB’s corporate veil is strong and liability should be limited to the equity and reserve at Sand Canyon or $389MM ($1.44 per share).
• Sand Canyon was acquired in 1997 and has always operated as a separate entity with a separate management team, board of directors, office space, insurance, etc.  HRB has also never taken a dividend out of Sand Canyon so it’s always been properly capitalized.
• For more details, I recommend reaching out to Oppenheimer for a transcript of a call they hosted with a corporate veil lawyer from St. Louis (the same state where HRB is based).  He walks through the various ways corporate veils can be pierced and says why it is a very low likelihood HRB will be pierced.

Key Stats / Current Valuation at $18.67

• Market Cap = $5.1B
• Total Debt = $1.5B
• Cash = $1.3B
• Enterprise Value = $5.3B
• Adjusted Enterprise Value = $4.7B
• HRB’s debt and cash balance fluctuate wildly during the year because of the seasonality in its business.  The average is $300-400MM of net cash, therefore, the above stats need to be adjusted.  The adjusted enterprise value is $4.7B.

• FCF yield = 10%
• EV/EBITDA = 5.6x (5.0x adjusted for cash seasonality)
• EV/EBIT = 6.2x (5.5x adjusted for cash seasonality)

Price Target

I estimate that EPS will be approximately $2.00 by FY2014 (April 2014).  If HRB gets more aggressive with buybacks when it sells its bank, EPS will easily be in excess of $2.00.

At 14x, HRB is worth $28.00 or +50% (+54% including dividend).  I think 14x is reasonable because this is where HRB traded earlier in the decade before it started diversifying into other businesses like Sand Canyon, RSM McGladrey, and HRB Financial Advisors.  It also seems reasonable given HRB will be growing earnings at 10-15% per annum.

At 12x, HRB is worth $24.00 or +29% (+33% including dividend).  12x is the median multiple HRB has traded at over the past decade.  This includes good times when HRB was squarely focused on tax (early 2000s) and bad times when investors thought there was risk HRB could go bankrupt because the corporate veil would be pierced from mortgage putback liabilities.

What’s the downside?  The 4.3% dividend provides nice downside protection.  Over the past decade, HRB’s yield peaked at 5.1% in the worst of times.  Given there is little risk to the dividend, I think this is a reasonable downside case.  At a 5.1% yield, HRB would trade at $15.68 or -16%.

Risks

• Bad Sand Canyon headlines.  There are a lot of HF holders so the stock could trade down on a bad headline.
• Putback risk / piercing corporate veil.  Low likelihood.  Once again, I recommend reaching out to Oppenheimer for a transcript of the call they hosted walking through this issue.  I also spoke with several lawyers through GLG that confirmed the corporate veil would be very difficult to pierce even if there was fraud.
• Digital takes share from assisted.  No evidence of this to date.  Assisted has hovered around 60% of total returns for a decade plus.  See slide 38 in HRB’s investor deck.
• Flat tax.  Low likelihood.  If anything, taxes are becoming more complex under Obamacare.
• Bank is not sold leading to more conservative capital allocation due to increased regulation.
• Bank is sold, but economics on financial products are lost.  HRB generates ~$300MM of revenue (10% of total) from its bank subsidiary.  8% of this revenue comes from fees on refund anticipation credits (RACs) and Emerald pre-paid cards and 2% comes from interest income on loans.  Based on mgmt’s initial conversations with potential acquirers, it would retain most of the economics on the RACs and Emerald pre-paid cards since they are both very low risk for the bank, but would give up most of the economics on the interest income on loans.

• Sale of bank / more aggressive capital allocation.
• Overhang of Sand Canyon continues to lift.
• Continued market share gain this coming tax season.
• Increased sell-side coverage.