Description

H&R Block is a small financial conglomerate best known for offering tax services (roughly 65% of rev, 55% of pretax). Less well known are its mortgage origination operation, a business services sector, and an incipient investment brokerage business. On a consolidated basis, HRB’s pretax margins are 23%; after tax margins are about 14%. Because their mortgages are resold nightly, and their offices are leased, the return-on-investment numbers are impressive: ROA= 12%, ROE= 34%, ROC= 24%. Total debt is just slightly less than cash, so the balance sheet is largely irrelevant. (EBIT to total interest expense= 17x.)
The analysis of this company is, naturally enough, a sum of the parts approach.
The investment brokerage business is the latest product extension offered by HRB, and one that has yet to make a profit – and probably should be closed. From 1q2002 to 1q2006, the business has a combined pretax loss of $433m, or roughly $1.30 per share. In the LTM, it lost $63m; it has never had a profitable quarter. The average revenue per ticket written is $123; average assets per client are $69k. Just about everyone in the full service brokerage business has been trying to shed these small ticket accounts because the economics are so terrible. This business is probably worth nothing – unless a large financial player with an existing investment brokerage platform acquired HRB.
The business services sector is exceedingly fast growing, and I think, a well developed extension of the HRB franchise. It validates HRB’s local presence throughout the country (and overseas). RSM McGladrey is the 5th largest public accounting firm in the US, primarily targeting the “middle market” corporation. It provides retirement plans, business valuations (broker), and payroll and benefit services, as well as conventional auditing and tax advice. With pretax income of $33m (fy/fy $30m vs. $19m), and with great growth prospects ahead, this business should trade at 20x EPS. Assuming $40m in pretax in F2006 (apr06), and a 37.5% tax rate, and 325m shares (down from 331m shs), this business is probably worth about $1.50 per share.
The mortgage service business is a very mundane, primarily sub-prime originator. The mortgages are sold every night to trusts and special purpose entities, and the retention by HRB is small. The potential income impact is relatively minor. It provided about $500m in pretax income last year, and $689m the prior FY, and should be worth 8x EPS of about $1.50, or $12 per share.
The tax preparation business earns about $650m pretax ($664m in F4/2005), and assuming the same ETR of 37.5%, and 325m shares, it will contribute about $1.25 per share. Applying a 16 multiple yields $20 per share in value. With the stock trading at $24, you have to ask yourself just two questions (we live in a more complicated world than Dirty Harry): is the tax business worth 16x EPS, and will the mortgage business implode? The tax preparation business is a non-cyclical, strong cash flow generator with steady organic growth and some potential upside surprises.
First, an increase in store locations; during F06, they increased units by 9% to 12,200. Second, a shift in mix to more profitable Company owned stores. The Company has notified franchisees that they will not be renewing their licenses when they expire; domestically the Company owns 7100 stores, franchisees 4100. While this will not add to total locations, the metrics on Company stores are substantially more favorable. For example, refund anticipation loans (“RAL”) participation rate at Company stores is 50%; franchise, 25%. Fees per customer are higher: the ASP in company owned stores is $158 vs. $ 136. Third, the Company has consistently increased prices per customer, without any visible elasticity. Fees in 2q2006 were up 12.6%, while number of clients in Company stores increased 7.4%. Fourth, in the software sales segment, Intuit has been gaining market share relentlessly. “TaxCut” software declined 14% in units in F05 (up 1% in dollars). The Company just hired two ex-Intuit guys to head this group. Revenue LTM was $44m, expenses $37m. How hard can it be to increase market share and profitability from virtually zero? Fifth, the RAL program with HSBC will be renegotiated this year, on terms which are widely anticipated to improve. Sixth, the digital filing option has been improved. Finally, the best comparable company is probably Jackson Hewitt (JTX) which trades at 18x current year EPS. Intuit, not a good comp, trades at 24x.
The second question (will mortgages implode ?) is impossible to answer. Gross margins have continued to compress, to just 1.01% in the last quarter vs. 2.83% twelve months ago, and 3.96% two years ago. HRB is probably the lowest cost provider in the industry, and has raised prices twice in November. Price increases are designed to provide margins of 1.75%. On a loss perspective, a 20% adverse change in prepayments (including defaults) is expected to cost the Company $47m or ($0.14) per share. Obviously, worse things could happen when the loan-to-value is above 78%, and the average loan is $188k. Additionally, HRB is expected very shortly to receive a license to operate a bank, which should eventually add about $0.30 per share in earnings. If you believe that we are looking at a massive housing bubble which will deflate quickly, this is not the stock for you.
On an EV/ EBITDA basis, HRB trades at $8.832b/ $1.273b LTM, or, 6.9x. With a market cap of $7.906 and FCF of $1.041 LTM, it trades at a 13.2% yield (7.6x FCF). Management has guided down twice this fiscal year, so there is little confidence in their current numbers, but FY06 should be $1.90-$2.15. So we are looking at a 2006 estimated PE of 12x. Estimates for F2007 are as high as $2.40, or 10x current price.

Catalyst

Mortgage business surprises to the upside. AMT filers opt out of self-filing. Approval of HRB bank received. Candidate for take-over.