|Shares Out. (in M):||185||P/E||7.2||8.0|
|Market Cap (in $M):||4,000||P/FCF||4.8||8.0|
|Net Debt (in $M):||325||EBIT||790||665|
|TEV (in $M):||4,325||TEV/EBIT||5.5||6.5|
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*Note - the above figures are estimates for FY21/22 and don't take into consideration the effects of the recently announced tax deadline extension
H&R Block (Ticker: HRB) has been a chronic underperformer for over a decade, generating a total return of 5.3% per annum versus 13.4% for S&P 500 (assuming dividends reinvested). That being said, the company has proven resilient against secular industry trends and idiosyncratic challenges. It possesses a strong franchise, generates a significant amount of cash, and has sticky, high-recurring revenues. In this write up, I make the case that HRB is in the midst of a transformation that will significantly enhance its go-forward earnings power, and will likely rerate the stock higher.
Founded in 1955, HRB offers assisted, DIY, and virtual tax preparation and ancillary services, primarily in the US although they have a small presence in Canada and Australia. As of January 31, the company leases 6,512 offices for its internally managed assisted tax prep operations, and has franchisees in another 2,759 offices. Franchisees pay the company 30% of gross tax prep revenues. Canada and Australia represent 1,086 and 464 offices respectively. They have 3,500 full time employees and hire up to 80,500 professionals during tax season, who they hire, train, and supervise to help clients prepare their taxes.
Over the last twelve months, the company generated 2.9bn in revenue, 626m of adjusted EBITDA, and 605m of free cash flow. There are 185m shares outstanding. Gross debt comes to 2.4bn but will drop to 1.5bn after the company pays down its revolver in the coming months as tax season winds down. They are a BBB credit, with the 3.875% senior notes due 2030 trading at a 191bp OAS over treasuries, 68bp wide of the ICE BofA BBB US Corporate Index OAS (as of last Friday).
For fiscal years ended April 30, 2016 through April 30, 2019, total taxes prepared and filed by HRB averaged 23.2m worldwide and 19.8m in the US, good for ~13% domestic market share. That is second only to Intuit’s TurboTax, who has ~25% total share and dominates the digital DIY tax return sub-sector with 66% market share. For their part, HRB is the only company remotely close to INTU with 15% of digital DIY share. On a trailing twelve month basis, HRB’s revenue sources were as follows:
US assisted tax prep (59.3%) – provided by tax professionals via a system of retail offices operated directly by the company. Also includes virtual products: Tax Pro Go and Tax Pro Review.
US royalties (6.9%) – the company receives 30% of gross tax return preparation and related service revenues.
US DIY preparation (9.0%) – offered online through website, via mobile app, or desktop software purchased online or through third party retailers or direct mail. Also includes virtual product: Online Assist.
International (7.4%) – similar offerings as in US but in Canada and Australia.
Refund transfers (3.9%) – RTs enable clients to receive their tax refunds by their chosen method of disbursement and include a feature enabling clients to deduct tax preparation and service fees from their tax refunds. Clients may choose to receive their RT proceeds by a load on their Emerald Card, by receiving a check or by deposit to an existing account. RTs are available in the US and are frequently obtained by those who 1) do not have a bank account 2) like the convenience and benefits of a temporary account for receipt of their refund and/or 3) prefer to have their tax preparation fee paid directly out of their refunds. Axos Bank has historically been HRB’s partner for this service but they recently terminated that relationship and are now working with MetaBank.
Emerald card (3.5%) – includes H&R Block Emerald Prepaid Mastercard and H&R Block Emerald Advance Lines of Credit. The Emerald Card enables clients to receive their tax refunds from the IRS directly on a prepaid debit card. The card can be used to fund every day purchases, and additional funds can be added to the card. EAs are lines of credit offered directly through offices, typically from mid-November through mid-January, in an amount not to exceed $1,000. Depending on the circumstance, the L/C may be used year-round. HRB purchases a 90% participation interest in the loans which have historically been originated by Axos.
Peace of mind extended service plan (3.5%) – Offered to US and Canadian clients, represent them if they are audited by a taxing authority and assume the cost (subject to certain limits) of additional taxes owed by a client resulting from errors attributable to H&R Block.
Tax identity shield (1.2%) – program that offers clients assistance in helping protect their tax identity and access to services to help restore their tax identity if necessary.
Interest and fee income on Emerald Advance (1.9%) – interest and fees from Emerald Advance L/Cs (described above).
Wave (1.8%) – acquired in FY19, Canadian software company that provides small business financial solutions including payment processing, payroll, and bookkeeping services.
Other (1.4%) – not disclosed
H&R Block has struggled in recent years as their bread-and-butter product – assisted tax prep – has encountered secular headwinds thanks to the increasing popularity of DIY tax prep services, namely TurboTax. They fired the old CEO and hired the current chief Jeff Jones in the Fall of 2017. Jones has a marketing background and previously worked at Uber and Target.
After a thorough internal review, Jones acknowledged on an earnings call in 2019 that they would need to reinvest in the business and therefore take EBITDA margins down from around 30% to the mid-20s. The company needed to modernize its product offering, review pricing, and improve the customer experience. They made incremental progress in all three, with an improved DIY product and the launch of its various Virtual Tax Prep products, lowered prices, improved price transparency, revamped their marketing, and invested in technology that helped their accountants be more efficient. Average throughput for company-owned operations improved by 5% in FY19 after being flat the prior two years, (this was partially aided by closing some less productive offices). Prior to the COVID-19 pandemic, revenues were trending up +3.6%, +8%, and +10.9% in the first three quarters of FY20, with US assisted revenues leading the way at +10.6% y/y in 3Q19.
HRB has experienced two other challenges over Jones’ tenure. First, the 2017 Tax Cuts and Jobs Act raised the standard deduction for US taxpayers, reducing the need for tax experts as more people chose that route rather than itemizing, hurting HRB’s pricing power. Second, several lawsuits were filed against HRB and INTU (among others) in 2019 which accused the companies of deceptive tactics to make it difficult for low-income tax filers to access the IRS Free File service. Free File is a public/private partnership between the IRS and member companies whereby the companies offer free tax filing services for low-income households in exchange for the IRS to not compete with them for everyone else. ProPublica did a deep dive on the matter in a piece released in October 2019. There is no denying this was a black eye for both INTU and HRB (although INTU seems to be more at fault). Because INTU blazed the trail for digital DIY tax prep, it’s safe to say they have more to lose in this case than HRB. And yet, the public markets don’t seem to think it is a big threat, as INTU’s stock has returned +44.6% since the article was published, outpacing the 36.0% return for the S&P 500. HRB by contrast is flat over that time period.
A few months after this article came out, the COVID-19 pandemic brought the world’s economy to its knees. On March 21, 2020, the IRS announced that, for the first time ever, the deadline for US tax filers would be extended from April 15 to July 15. The announcement caused HRB to draw its full 2bn revolver. Because HRB loses money in the first three quarters of its fiscal year, which ends April 30, the loss of income from delayed filers and subsequent revolver draw resulted in the company violating its debt / EBITDA covenant. The covenants include 1) debt / EBITDA cannot exceed 3.5x on quarters ended April 30 July 31, and October 31 and 4.5x on January 31 2) interest coverage (EBITDA / interest) must be greater than 2.5x at the end of any quarter and 3) various covenants restricting the company’s ability to incur debt, create liens, sell assets, etc. There are provisions for an equity cure for certain defaults; fortunately, the company’s creditors waived the breaches without such a cure and the company expects to be in compliance in fiscal year 2021. That said, the credit stress caused the company’s stock to hit at a multi-year low of around $12.
Jones and his team have been able to capitalize on the tax prep industry havoc and taken share. Over the last twelve months, HRB total assisted volumes stand at 12.45m; substantially up from FY19 (11.62m) and the highest it’s been in five years. Total US taxes prepared over the last twelve months stands at 22.9m, also the highest in years. This has come despite 20% of HRB’s offices being closed during FY20 tax season. The investments HRB made in virtual and DIY digital tax prep have proven prescient.
The company also took advantage of the low-rate environment and refinanced its 650m tranche of bonds due to mature in 2021 with new notes due in 2030 that pay a 3.875% fixed coupon.
Perhaps most importantly, the company hired a consultant to analyze strategic opportunities, and the result was the acquisition of Wave in 2019. Wave is a Canadian-based SaaS company that sells payment processing, payroll, and bookkeeping services to small businesses. It utilizes a “freemium” model – basic services are free and customers may choose to pay up for premium services. Given the high failure rates for most small businesses, this model makes sense – offer the services for free, then as the business grows they will need to pay up for the premium service. This is HRB’s answer to INTU’s Quickbooks. At first glance, it seemed like HRB may have overpaid for Wave, which they purchased with cash for $408m for around 10x sales. They also took a Goodwill charge in 2020 for 106m based on the hits to Wave’s top line as a result of the pandemic and subsequent recession. However, the company gave an investor presentation this past December where they laid out the case for Wave as a strategic asset that will enhance their go-forward earnings power. Some of the more compelling points they laid out are as follows:
Management guided for 3-6% revenue growth, which enables the company to grow EBITDA 1.5x faster and EPS 2.5x faster than topline thanks to fixed cost leveraging and huge recent share repurchases (26% of the float since 2016). I found the presentation to be compelling, and think the company has a real shot at success for the reasons outlined.
Below is a simple model I put together. I think this is a scenario where I’d rather be approximately correct rather than precisely wrong. I take the mid-point of management’s revenue guidance, and make some assumptions about fixed vs. variable costs, and growth rates. One note – my 2021/2022 estimates are based on the low end of management’s guidance, and doesn’t adjust for the recent IRS extension for tax filings to May 17, 2021. Additionally, I use FY19 (i.e. the last “normal” tax season) as the reference year for future projections:
The key point here is that the company does not need a heroic effort on the top line to significantly enhance its earnings power.
As far as valuation, there are multiple ways to look at it. For a more conservative valuation, I capitalized an estimated 315m of run rate lease costs (FY20 operating lease costs were 242m plus 71m of variable lease cost gets us about there) at 8% and added to the TEV, then added the 315m to my estimate for FY22 EBITDA:
For investors who are comfortable with fully leveraged FCF yields, at the current price the yield is around 12%:
It should be noted that the current dividend yield is nearly 5%. So in essence, shareholders are getting paid a 5% dividend and 12% FCF yield and getting the growth upside for free.
My target return for this investment is around 200% based on the following math:
Given the projected 13.5% annualized growth in FCF per share, I think selling for 10x EBITDAR in a few years is a reasonable target.
As far as downside goes, I think investors can safely assume around $15 as a floor. The company repurchased over 150m of stock around $15/share in FY20, and I would expect them to be able to continue to do so given the recurring revenue and high cash generation capabilities of the business. I also think these attributes, combined with the strong franchise/brand, would make HRB an attractive target for a PE firm. At $15/share, the EBITDAR multiple would be around 6x. I think a PE firm would consider such an acquisition a steal, given most deal multiples are in the low-mid teens these days.
I believe this is an attractive risk-adjusted investment, with nearly 7:1 upside/downside. And that is without even considering a “dream” scenario where HRB takes meaningful share from INTU. INTU sports a 100bn market cap on a 7.7bn sales base; while it’s unlikely HRB ever commands that sort of premium multiple, it’s also not completely far-fetched to see HRB become a 20bn+ company one day.
The major risks to this investment are as follows:
Execution risk – there is certainly risk that the move into small business services doesn’t work, that the Wave acquisition proves to be a waste of money, and the company is unable to return to reasonable top line growth. It’s worth noting that HRB did formerly own a bank, which they closed and divested in 2015. That being said, I believe Wave and Block Advisors’ value proposition for small businesses will be powerful, and the company has a huge opportunity to take share from INTU with its disruptive model. The push to digital payments and banking for an underserved segment of the US population also makes strategic sense and could provide further upside.
Litigation and reputation risk – the lawsuits filed against HRB, and potential reputational risk, is probably the biggest risk to this thesis. HRB is unable to determine at this time any potential damages from the various lawsuits filed against them in relation to the Free File scandal. It’s worth noting that they terminated their membership as of last October. By expanding into new business lines, and diversifying away from consumer tax prep, I believe they are reducing the overall risk to the business (especially relative to INTU). I also believe that recent campaigns such as “Make Every Block Better,” their expedition of stimulus check distribution, and emphasis on helping small businesses creates goodwill with both their customers and Uncle Sam. Nobody wants to have a reputation for ripping off working-class folks of their hard-earned money, and while they may be guilty such practices in the past, Jones and his team has the company trending in a new direction. And they are cleaning house – a recent director who had been with the company since 2004 resigned; indeed, Jones noted in the December presentation that 45% of the directors are new to Block or have been promoted to a new role.
Changes to tax submission procedures – there are proposals being made for tax returns to be “pre-populated” by the IRS, then reviewed and submitted by the filer, like a credit card bill. I find it unlikely this would work for people and businesses with multiple income streams. Any pressure on the tax prep industry will be to the benefit of HRB, who possesses better resources and scale than mom-and-pop accountants, and can therefore take share.
Block Advisors 2021 rollout results in better-than-expected topline growth in FY22
Wave Money launch allows company to quickly gain share in digtial banking and payments
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