H&R Block HRB
December 23, 2010 - 5:42pm EST by
sfdoj
2010 2011
Price: 12.69 EPS $1.46 $1.57
Shares Out. (in M): 305 P/E 8.7x 8.1x
Market Cap (in $M): 3,872 P/FCF 7.5x 7.0x
Net Debt (in $M): 198 EBIT 652 730
TEV ($): 4,070 TEV/EBIT 6.2x 5.6x

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Description

I am recommending a long position in the common stock of H&R Block.

 

Background

H&R Block was founded by the Bloch brothers in 1946 and since 1955 has had its current name and specialized in tax preparation for individuals. In the late 1970s the company started diversifying into other businesses, including legal work, computer timeshares, financial software, business accounting and consulting, mortgage origination, financial advisory, and credit cards. In FY07 and FY08 they suffered large losses from their Option One subprime lending operation and in 2007 former SEC Chairman Richard Breeden won a proxy battle which resulted in his election as chairman. He fired the CEO and brought in Russ Smyth, former President of McDonald's European division. He also sold the financial advisory business and the mortgage servicing business, keeping only tax preparation, business consulting, and the legacy subprime mortgage portfolio. Smyth stuck around for two years then left this past summer after failing to grow the tax business. Breeden is still the chairman, and his investment fund is the fourth largest shareholder with 13.3mm shares (4.4%) and an approximate cost basis of $20.90 (-38% underwater not counting dividends).

 

Investment Highlights

New Management brings positive changes

Alan Bennett was Aetna's CFO from 2001-2007, the interim HRB CEO from 11/07 to 8/08, and is now the permanent CEO since July 2010. He has been a board member since 9/08. Jeff Brown was the interim CFO from May 2010 and has been the permanent CFO since September 2010. He has been with HRB in various financial roles since 2002.

Management has made some changes to the website (http://www.hrblock.com/) that should improve the company's conversions. Last year website traffic increased by 25% but new clients only increased by 4%. This year they have reduced the number of clicks required to get to a filing from 7 to 3. Anecdotally the website appears much simpler and cleaner to me than it did last year. Bennett has also given all digital tax employees direct P&L responsibility so that their compensation depends directly on growing clients.

 

Leveraged to an improving economy and falling unemployment

Historically the number of federal tax returns filed in the United States grew +1-2% per year. With the financial crisis beginning in 2008 the number of returns filed has shrunk by 1-2% each of the past two years. As the economy continues to expand and as unemployment shrinks there will be more wage earners and therefore more tax filers. A growing market in 2011 and 2012 will be significant tailwind for the company. As HRB has significant operating leverage, if they can grow revenues, operating earnings will grow at a rate at least double that of revenue growth.

 

TaxAct acquisition could fix their digital business

Acquisition of the number 3 player in digital tax preparation announced 10/13/10 and expected to close in early 2011. The acquisition price is $287.5mm, which seems high given that TaxAct generated only $70mm in revenues with 50% EBITDA margins last fiscal year ending in April (4.1x LTM revenues and 8.2x EBITDA) . But I believe this will turn out to be an important and value-creating acquisition for a few reasons: 1) TaxAct has grown revenues by 22% per year from 2006 to 2010 whereas HRB's digital revenues have stagnated over the past two years, 2) HRB gets TaxAct's founding management team, who will likely be in charge of all digital strategies in FY12, and although hrblock.com looks better than it did last year, TaxAct's team can't do much worse and can likely do a lot better strategically with HRB's resources, and 3) TaxAct targets lower income early season filers, as their average fee is $14 per return. Early season filers is where HRB most struggled last year so they should do better at capturing their fair share this year both through taxact.com and from learnings gleaned from TaxAct's practices.

 

Shift from 1/3rd franchised to 50/50

This shift temporarily boosts cash flow due to the sale of offices to franchisees, improves profit margins as franchised stores produce a pre-tax margin of about 85% versus 33% for owned stores, and improves company-wide productivity as franchised stores perform better on most profitability metrics than owned-stores. The company sold 267 offices in FY10 and 76 offices in FY09. They plan to continue to sell offices in order to reach a balance of owned/franchised of closer to 50/50, which would require the sale of another 1400 offices.

 

Tax preparation is still a high ROIC business, with prodigious FCF

Since 1988 ROIC has averaged 16.6% according to Bloomberg, each of the last two fiscal years it has been 21%.

Over the LTM HRB has produced $725mm of FCF, and returned almost 100% of that to shareholders by repurchasing $534mm of stock and paying $195mm of dividends, equivalent to a FCF and shareholder yield of 18.3% on the current market cap.

 

Extremely low expectations and poor sentiment

HRB has been the second worst performer in the S&P 500 YTD -41%. At 8x TTM P/E the stock is trading near its all-time low relative to the S&P 500, within 15% of its all-time low of 6.8x and at one-half of its L10Y average P/E of 16x.

 

Huge stock buyback relative to market cap will dramatically increase EPS even with stable profitability

HRB announced a $2B stock repurchase program in June 2008 to occur over the next four fiscal years (through April 2012). In December 2009 they said the buyback might take a year longer than initially expected, meaning it could extend into FY13. Thus far they have repurchased $644mm, including $534mm over the LTM, leaving $1.356B remaining. As a percentage of the current market cap that is 35%. With stable earnings, if the entire remaining authority were purchased at the current stock price EPS would increase by +53%.

 

Attractive and stable 4.7% dividend yield

Now at fifteen cents paid quarterly, the dividend has grown on average 8% per year since 2000. It has been fifteen cents for 10 quarters-in the past they raised it every year. So it is possible that they will raise it, but given the all-time high yield (L10Y mean/median is 2.3%/2.1%) and the emphasis on stock buybacks a dividend raise is not very likely.

 

 

Business Description

Tax preparation-in store, online/software

HRB helps individuals file their Federal and state tax returns in their owned and franchised stores, over the phone, via their packaged software installed in home computers, and online at www.hrblock.com. HRB has 11,506 retail offices in the United States, 1269 offices in Canada, and 374 offices in Australia, for a total of 13,149 offices worldwide where tax professionals assist customers in person with their tax returns. In the U.S. 37.5% of the offices are franchised and 62.5% are company-owned. HRB had 7,700 full-time employees on 4/30/10, but employed a seasonal high of 110,400 at the height of tax season. Tax preparation fees are about $2B annually, which works out to about $100 per return filed, which is a blended average of in-store (more expensive) and online filings. Prior to last tax season HRB's digital product was called TaxCut; it was rebranded as H&R Block At Home last season. Digitally, HRB's products were used to file 2.19mm returns via software and 2.89mm returns online.

 

Associated financial products

To entice customers to use its tax preparation services HRB provides a variety of associated financial products, most of which are offered only to tax preparation customers. These are: Emerald prepaid debit card, refund anticipation loans (RALs, limit $9,999), refund anticipation checks (RACs), Emerald LOC (limit $1,000), Peace of Mind (POM) guarantees. Revenues for these products as a whole are reported as individual line items in the tax services segment, but they are lumped in with tax when the company reports segment profitability. In aggregate, fees and interest from these products generated $404mm in revenues in FY10. I estimate that pre-tax profit for RALs/RACs is likely about $200mm; the lack of data on the other products makes it difficult to estimate their profitability.

The Emerald card is the second largest prepaid debit card in the United States after Green Dot (3.3mm) with 2.5mm users, and a source of potential opportunity now that interchange fees for prepaid debit cards will not be regulated as part of the Durbin amendment.

RALs produced $146mm of revenues and $90mm of pre-tax profit in FY10 versus $140mm/$57mm and $190mm/$87mm in FY09 and FY08. According to the company, should they lose the ability to provide RALs this tax season, if every potential RAL customer instead used an HRB RAC, overall profitability would not change.

 

Business Services

RSM McGladrey is the majority of this segment which consists of tax and consulting services, wealth management and capital markets services to middle-market companies in 88 cities and 26 states including 20 of the 25 top U.S. markets. One year ago the company expected to improve margins in this segment from a historical average of about 8.5% to the low double digits over the next few years and to potentially sell the business at that point. It is not clear if that opportunity still exists. At a minimum the distractions of last year with regard to RSM's relationship with its associated attest firm, McGladrey & Pullen, will not be present this year.

 

Legacy loan portfolio and origination liability from Option One (now known as Sand Canyon Corporation (SCC))

Please see the slide presentation from F2Q11 conference call (http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NzM0OTd8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1) and read the call transcript for a detailed discussion of HRB's potential liability. As a brief summary, although SCC originated $169B in mortgages during HRB's ownership of the company, $84B of that was in the worst years of 2005-2007 from which all claims have arisen to date, and of that $44B is outstanding. SCC ceased originating mortgages in December 2007. 95% of originations during this period were subprime first-lien loans. As part of the sale of the whole loans (1/3 of total) or SCC's securitization of these loans (2/3 of total), SCC made certain representations and warranties that the loans conformed to the applicable underwriting standards described in the associated documents. Since May 2008, some investors in these loans have been asserting that the loans were not compliant with these reps and warranties by filing a "claim" with HRB. Once a claim is received HRB decides to accept it and repurchase the loan or pay the investor's loss, or to dismiss the claim if they feel there was no breach. Owners of dismissed claims can still sue HRB but the burden of proof is on the plaintiff to show clear evidence of a breach of the reps and warranties.

 

Putback claims have declined since the first assertion in May 2008, and HRB's total losses have been $58mm out of $707mm in total claims, which has reduced the initial loss reserve from $243mm to $185mm. Whole loans are about 2/3rds of the outstanding balance, and there have been no whole loan claims for the past two quarters. Private Label Securitization (PLS) claims have increased a bit over the past five quarters (from zero in the five previous quarters), but claims are lumpy so it is difficult to discern a trend. Of the $44B of whole loans or PLS's outstanding, about $13B defaulted within the first two years, which is the pool from which valid claims have been emerging. The vast majority of recent claims have come from monoline insurers, which insured $2B of PLS's or loans currently outstanding, and securitization trustees, which covers about $14.3B of PLS's currently outstanding. The percentage of these loans that defaulted within two years of origination is unknown, however, if it is proportionate to the percentage of early defaults from SCC's originations overall-32%-the pool from which valid claims will likely come is $4.6B. While $4.6B is still a large number relative to HRB's $185mm loss reserve and $880mm of equity, it is not nearly as scary as $169B. Supposing that half of this amount submits claims, which is an extreme assumption, and that HRB's loss experience is similar to what it has been on submitted claims over the past 30 months (10%), the loss would be $230mm, or $45mm greater than the reserve, and should decrease the value of the stock by about 9 cents. It is difficult to determine exactly how big a loss above and beyond the loss reserve the stock price is reflecting, but my guess is $300-600mm after tax, or about $1-2 to the stock price. Although it is possible that claims activity could increase dramatically from even the recent past, actual losses from legitimate breaches of representation and warranty breaches appear to be adequately covered by the loss reserve.

 

In addition to the liability as a result of the legacy origination business, HRB owns a legacy portfolio of subprime residential mortgages, 64% of which were originated by SCC. The current principal balance is $620mm down from $761mm at 10/31/09 and $869mm at 10/31/08. Of the $620mm principal outstanding, excluding performing modified loans, $199mm of the balance is non-performing, or 32%. Against this amount HRB has a loan loss allowance of $87.6mm, which indicates a severity of 44%. Although charge-offs continue to be high ($22mm over L6M), new delinquencies are very low at $1.4mm, so it appears that absent another significant decrease in house prices or a large increase in interest rates that the mortgage portfolio will not be a significant drag on future earnings.

 

Fiscal year ends April 30th.

 

Profitability

In $ millions

 

Year

FY ending 4/30

2008

2009

2010

Revenues

 

 

 

 

Tax Services

 

4,087

4,084

3,874

Business Svcs

 

2,989

3,033

2,975

Consumer Fin Svcs (sold)

 

143

142

-

Corporate

 

14

11

39

Pretax Income

 

745

826

739

Tax Services

 

786

880

822

Business Svcs

 

89

96

59

Consumer FS

 

10

(15)

-

Corporate

 

(140)

(136)

(142)

Tax Margin

 

26.3%

29.0%

27.6%

Biz Svcs Mrgn

 

9.4%

10.7%

6.8%

Overall Margin

 

18.2%

20.2%

19.1%

 

Typically HRB earns a pre-tax profit of about $100mm in the January quarter, $1.1B in the April quarter, and loses about $200mm in the July and October quarters. Conservatively, core profitability appears to be in the range of $660-880mm for tax and financial products, $60-100mm for business services, corporate expense has been decreased to about $110mm, for a pre-tax profit of $610-850mm. Applying a tax rate of 39%, after-tax profit should be in the range of $375-520mm. I display various EPS scenarios in the table below:

 

 

No Buyback completed (305 S/O)

Entire Buyback done at $18 base price target (230 S/O)

Entire Buyback done at current price (198 S/O)

Low

$1.23

$1.63

$1.89

Midpoint

$1.47

$1.95

$2.26

High

$1.70

$2.26

$2.63

 

Consensus for FY11 / FY12 is $1.57 / $1.75.

 

 

Competition

There were about 140 million Federal tax returns filed in the U.S. in 2010. About 60% of those returns are filed by a paid tax preparer, what is known as assisted tax preparation. In the assisted tax prep category, HRB had by far the largest market share at about 15.6%. Second was Jackson Hewitt (JTX) with about 3%. Liberty Tax Services is third with about 1.5%. After those three there are many thousands of tax preparers who each have much less than 1% of the market. Overall it is an extremely fragmented market.

The DIY market is much more concentrated, dominated by Intuit (INTU) with its TurboTax product, which facilitates about 27mm tax filings annually (~45% share of DIY), about half of which are via packaged software and half of which are online through their website. HRB is number two in the DIY market with its H&R Block At Home software and online product with about 6mm units and 7.5mm tax filings facilitated (~13% share). TaxAct is the number three player with 5mm filings. All companies offer some filing services for free as a lure and then up-sell customers with add-on services (e.g. state filings). Generally online DIY is the least expensive option, then packaged software, then in-store assistance. TaxAct's average charge per filing is about $14, TurboTax is about $40, and HRB's is $100 as they don't break out digital from in-store tax revenues, although their digital DIY prices are generally lower than those for TurboTax.

 

Management

During Bennett's tenure as CFO at Aetna the stock price rose 580%, or about 40% per year, versus the S&P managed care index's rise of 220% or about 22% per year. Excluding 2002 when the company lost money, average ROIC was 16% versus about 12% average for its largest competitors. Bennett received 1mm 10-year options with a strike price of $14.37 as part of signing on as CEO. It appears that he was paid about $12mm total during his six years as CFO of Aetna, and while he currently makes a good salary of $950,000 from HRB as well as about $500,000 annually for his board seats on HAL and TJX, the stock options he received will be a meaningful contribution to his net worth if he can double the current stock price. So it appears that he is well-incentivized to do this, and aligned with shareholders.

 

Why is the stock mispriced?

1)      One explanation is the perception that HRB's market share decline of the past two years is a secular trend away from assisted tax preparation to DIY. If I believed that I would be much less likely to buy the stock. The percentage of US tax filers who have used a tax preparer has not changed in the past 8 years, staying at about 60%, and in fact DIY had a larger share in 1999-2001 than it does today.

2)      SCC originations are really large relative to shareholders' equity and there has been a lot of noise in the press about putback liability. As I described above, the company's loss experience over the past 30 months leads me to believe that the current loss reserve will be adequate.

3)      The company has disappointed investors in the past and therefore new and former shareholders will not buy the stock until the company demonstrates that they can at least stabilize tax market share.

 

 

Balance Sheet

$880mm of equity capital including $300mm at wholly owned subsidiary SCC

 

$1B of bonds: $600mm of 7.875% bonds due 1/15/13 currently yielding 5% and $400mm of 5.125% bonds due 10/30/14 yielding 5.1%

$75mm FHLB borrowings at a WACC of about 2.1%

$40mm of commercial paper

$11.5mm of capital leases

$31mm of past acquisition future obligations

 

Total debt = $1.158B; $93mm of this total is short-term debt.

Cash and cash equivalents = $960mm.

TTM recurring pre-tax profit = $776mm

Debt/PT Profit = 1.5

Net Debt/PT Profit = 0.3

Debt/Equity = 1.3

 

Due to the extreme seasonality of the tax business, the amount of debt and cash on HRB's balance sheet increases dramatically in January due to early tax season funding obligations. At the end of January each of the past two years total debt was about $2.8B. So it might be more appropriate to calculate the average quarter-end debt balance over the past 4 quarters, which is about $1.5B. And the average L4Q cash balance is $1.4B. So Debt/PT Profit might be closer to 2x, but Net Debt/PT Profit would be closer to 0.1x.

 

HRB also has a committed line of credit (CLOC) of up to $1.7B, due 7/31/13. From the 10-K: This facility bears interest at an annual rate of LIBOR plus 1.30% to 2.80% or PRIME plus .30% to 1.80% (depending on the type of borrowing) and includes an annual facility fee of .20% to .70% of the committed amounts, based on our credit ratings. Covenants include: (1) maintenance of a minimum net worth of $650.0 million on the last day of any fiscal quarter; and (2) reduction of the aggregate outstanding principal amount of short-term debt, as defined in the agreement, to $200.0 million or less for thirty consecutive days during the period March 1 to June 30 of each year ("Clean-down requirement"). At October 31, 2010, we were in compliance with these covenants and had net worth of $879.8 million. We had no balance outstanding under the CLOCs at October 31, 2010 or April 30, 2010.

 

 

Valuation

Relative valuation:

Since 2002 HRB has traded at a trailing multiple of about 0.9x that of the S&P 500, with a low of 0.46x this past October, and a high of 1.45x in February 2007. Its current ratio of 0.51x is 2 standard deviations below its L9Y mean. The S&P 500 at 1257 is trading at 14.7x 2010e EPS and 12.9x 2011e EPS. If one year from now HRB were to rise to its mean relative valuation to the S&P 500 and the S&P 500 were to trade at the same trailing multiple as it is today, HRB's trailing multiple would be 14.7 x 0.9 = 13.2x 2011e EPS. CY11e EPS = $1.56. 13.2 x 1.56 = $20.60

Absolute valuation:

Core net profitability of about $450mm, assuming half of the remaining buyback is completed at the current stock price, yields EPS of about $1.80. Discounted at a cost of capital of 10% with a perpetual growth rate of zero yields an $18 stock price, my base case scenario below.

 

18-month return forecasts and estimated probabilities:

Base case: $18, +40%, 2011 market share falls less than expected, core profitability is stable, $1.80 in FY12 EPS, fear of putbacks recedes with time, multiple rises to 10x, a 35% discount to its L9Y average and a 24% discount to its relative multiple to the S&P 500. p=50%

Upside: $26, +100%, 2011 market share stabilizes, tax revenues grow, putback claims continue to fall, buyback continues throughout 2011, visibility to $2 in EPS in FY12 potentially $2.40 in FY13, trading at its historical relative multiple to the S&P 500. p=35%.

Downside: $8.50, -33%, market share losses continue, RAL loss hits FY11 earnings by 19c, putbacks accelerate and both the $185mm loss reserve is exhausted as well as SCC's $300mm of equity (cost is $1 to the stock), buybacks cease, multiple is all-time low of 6.8x on lowered EPS of $1.40. p=15%.

Expected Value = $19, +50%

Base / Downside: 1.2x

Upside / Downside: 3x

 

 

Risks

Continued market share losses in tax prep

Market share loss in tax segment could continue for a variety of reasons. Despite increasing tax code complexity, software is getting sophisticated enough to compensate for this and therefore the shift from assisted tax preparation to DIY over the past two years could actually be secular. If this is the case, HRB will need to improve its digital offerings significantly. The TaxAct acquisition could be key in this effort, but last season's digital results (pre-TaxAct) where they grew returns filed by only +0.4% versus TurboTax's +11% growth is not encouraging.

SCC mortgage putbacks

Mortgage putback claims increase and HRB is forced to begin buying back delinquent loans and MBS at a much higher rate. Given the size of the maximum liability-about $44B-this could conceivably wipe out the $300mm of equity at SCC. Although HRB has only guaranteed an additional $1.7B of SCC loans, and we could therefore theoretically argue that HRB's liability is capped such that a wipeout of its entire $880mm of equity is extremely unlikely, it's not clear that this would protect the HRB equity and that the stock price would not decline materially if claims increased dramatically and they were forced to declare bankruptcy for SCC. Even if they did that HRB would likely be sued and the best outcome in that scenario would probably be a distressed sale of HRB which would be a very negative outcome for us as stockholders.

Share buyback suspension

In a less adverse scenario, should mortgage putback claims increase, HRB would likely slow or halt its share buyback program, which could dramatically decrease our future EPS expectations and in the best case scenario limit our expected upside.

Loss of RAL capability

Should HRB be unable to negotiate with HSBC an acceptable solution for HSBC to provide RALs for the 2011 tax season, HRB could lose further market share since competitors Jackson Hewitt and Liberty Tax Service both will offer RALs at most locations. HRB has 11.5k locations versus 6.4k for Jackson Hewitt and 3.2k for Liberty. This present some risk that Oppenheimer has quantified as 6-19c of EPS versus the $1.58 consensus estimate. Even if HSBC provides RALs for the coming tax season, it appears unlikely that they will provide them for future tax seasons after 2011. To mitigate this risk, HRB seems to be expanding its other financial products. With the removal of the debt indicator this year, providing funding for RALs will probably not be a profitable business for anyone, not just HSBC. As a result, even if HRB is at a disadvantage this season, most likely this will not be a long-term competitive disadvantage as most if not all other RAL providers will cease operations in 2012, particularly if their experience in 2011 is not profitable. There are only two other RAL providers as far as I know, Republic Bancorp and Santa Barbara Tax Products Group, and therefore the vast majority of the thousands of tax preparers do not offer RALs.

Consumer Financial Protection Agency

The newly formed CFPA could crack down on RACs and HRB's Emerald LOC, both of which if treated as loans charge usurious interest rates. The IRS has proposed a fee-splitting arrangement for FY12 which could make it easier for taxpayers to pay tax preparers and reduce the need for settlement products. As financial products are very profitable for HRB, any reduction in their availability could significantly decrease the company's overall profitability.

Legacy mortgage loan portfolio

If house prices fall significantly and interest rates rise, as 59% of the loan portfolio is composed of adjustable rate loans, defaults could significantly increase which would require a much larger loss provision. A downside scenario might be if the current loans defaulted at the same rate as the non-current loans have defaulted as a percentage of the entire portfolio-32%-and severity is 60% on all defaults, losses would be $200mm. The loss reserve is $88mm so this would imply an after-tax hit to book value of $68mm/305mm shares = $0.22 per share. But the stock price would probably fall more as a loss of this size would delay the stock buyback and cause investors to question the rest of the loan portfolio.

 

 

Conclusion

Although there are a number of potential pitfalls with this investment, I believe that the combination of all-time cheapness, the support of the buyback, the TaxAct acquisition, and improving unemployment trends make it a very good risk/reward over the next 18 months.


Catalyst

TaxAct deal closing

If the deal closes prior to the beginning of tax filing season (1/15/11) it will be 5c accretive to FY11 EPS. If it closes significantly later there will be no benefit to FY11 EPS but potentially significantly more benefit to FY12 EPS.

Settlement with HSBC over RAL provisioning

This was expected in December but now appears it will be an early January event. As HRB already announced that the outcome will either be no RALs or RALs with reduced economics, only a no-RAL outcome would likely make the stock fall. And it is unclear to me why HRB would not be entitled to a significant payment in that scenario since its agreement with HSBC specifically mentions removal of the debt indicator as an insufficient reason for canceling the RAL agreement. Although it doesn't appear that consensus FY11 EPS estimates have fallen as a result of HRB's announcement, the potential worse-case outcome does seem to mostly be in the stock at the current price. The reason I believe this is that despite better than expected earnings announced on December 7th and a well-received detailed explanation of SCC's mortgage putback experience to date and potential future exposure, HRB stock fell -6% the day after the announcement and remains below the average price from the week before the earnings announcement.

Stock buyback

Once cash flow and earnings turn positive in early 2011 HRB will resume its $2B buyback program, of which $1.36B remains.

Announcement of early tax season results

Most of the market share loss last year was from early filers, those who filed in January through March. HRB will report F3Q11 results the first week of March and give an update on filings through the end of February. This will give investors a sense for how their in-store and digital initiatives are working.

Periodic updates throughout tax season

HRB typically gives updates at the end of March and end of April

F4Q11 earnings release

This report, released the last week of June, will give the definitive answer to HRB's success or failure during 2011 tax season.

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