After the seven month market melt up, it is quite difficult to find a long idea that has: a cheap valuation, a real dividend, a brand/franchise, analyst sentiment that will likely improve, and multiple catalysts in the form of positive surprises. H&R Block (NYSE: HRB) possesses all of these characteristics and could be a double from current levels regardless of what the overall market does. H&R Block is a world-class franchise that is on the precipice of a fundamental improvement in its competitive landscape that will provide HRB with its largest competitive advantage in decades. The changing operating landscape discussed below should drive earnings estimates materially higher, which will lead the cadre of neutral rated analysts to upgrade their ratings. Shockingly, not one analyst has written about the disruptions in the financial service products segment, including refund anticipation loans (RALs), which could cripple H&R Block’s competition. To top it off, HRB trades at a 37% discount to the S&P 500 with a healthy dividend yield to boot.
As Wall Street will come to realize (to the benefit of HRB), RALs represent roughly 6% of earnings at H&R Block. However, without RALs, most of H&R Block’s competitors would lose 100%+ of their earnings. As I articulate below, the disruptions occurring today could impact more than 11 million returns in 2010, compared to 15 million tax returns performed at HRB’s retail locations. Under the best case scenario for HRB’s competitors, they will have to significantly increase their pricing. Under the worst case, many will be out of business.
If HRB can capture a small portion of the market that is impacted by this disruption, it will have its best tax season in years, resulting in substantially higher earnings. With the potential to add more than $0.25 of incremental earnings in the tax business, more than $0.10 from the resumption of their share repurchase program, and a reduced drag from subprime, HRB’s earnings power will exceed $2.00 per share next year. At a meager market multiple of 15x (although this franchise should trade at a premium), HRB will trade north of $30 per share by early tax season (mid January / early February).
Refund Anticipation Loans
Financial service products have historically been an important part of the economics of the retail tax preparation business. A RAL is a short term loan, usually around eleven days, and is secured by a taxpayer’s expected refund. RALs have proven to be attractive products because they provide a filer with immediate access to his/her tax refund. Another popular product, refund anticipation checks (“RACs”, also known as “assisted returns”, “refund transfers” or “electronic refund checks”), is a lower fee product that provides quick access to a refund, typically in 10 to 15 days (compared to six weeks for the IRS to send a check). Based on their egregious APRs (as high as 350% in some cases), these financial service products have been in the cross hairs of consumer advocates for years.
The IRS does not allow tax preparation firms to provide RAL loans. As a result, tax preparers rely on banks for the funding of RALs and RACs. For example, HSBC (HBC) provides RALs for HRB customers. Under their multiyear contract that runs through 2011, HRB retains 49.9% interest in all RALs offered through HSBC. In 2007, HRB and HSBC proactively responded to concerns of consumer advocates and cut the APRs on their RAL offering to 36%. In fiscal 2006, HRB earned $107 million of pretax profits from RALs, or 22% of total earnings. In fiscal 2009, as a result of the lower APR, RALs contributed only 6.5% of HRB’s earnings (10k, page 9). HRB has responded to regulatory concerns and reduced its reliance on the RAL business. However, H&R Block’s competition maintains operating and financial models that are entirely dependent on RALs. As a result, it is my belief that any disruption to the RAL market, or legislative change banning RALs, would create a huge competitive advantage for HRB.
Tax Prep Competition – Take away the RAL, take away the earnings
HRB’s competitors may not exist without RALs. For example, in fiscal 2009 Jackson Hewitt (NYSE: JTX) derived $59.9 million of revenue from “financial product fees.” According to analysts and company representatives, greater than 85% of this line item was RAL and RAC fees that have minimal associated costs (according to management it is roughly 80% margin). At 80% margin this represents 104% of pretax earnings of $45.9 million. Simply put, Jackson Hewitt (.pdf) loses money without RAL and RAC fees.
Jackson Hewitt’s business is geared towards the early tax season and driving large fees from financial services. In fiscal 2009, the company completed 2.96 million returns and sold 2.75 million financial products—a massive attach rate relative to HRB’s - 15 million returns with only 3 million RALs. JTX offers their financial products (RALs and RACs) through two bank relationships: Republic Bank and Santa Barbara Bank & Trust. Customers typically pay around $130 for a RAL (average size loan of around $3,000), with the economics split between the banks and JTX. The APR’s on JTX’s RALs usually represent a 100% to 180% APR (versus 36% at HRB).
Jackson Hewitt is not alone in their reliance on RALs and RACs. Another large competitor, Liberty Tax (.pdf), generated $23.8mm of revenue in “bank product and tax discount income” versus $20.8 million in pretax earnings. Assuming Liberty Tax’s financial services revenue has similar margin characteristics to those of JTX’s, Liberty would also generate almost all of its earnings from RAL / RACs. I believe thousands of independent firms--affectionately known as “RAL shops” in the industry—operate with a similar reliance on financial service fees as JTX and Liberty Tax.
Trouble at Two Largest RAL / RAC Providers
I believe a massive disruption in the U.S. tax business is currently underway that could be devastating to firms that are reliant on financial service fees and create a fantastic competitive backdrop for HRB. Republic Bank (NASDAQ: RBCAA) is the second largest provider of RAL and RACs in the U.S. Republic has key relationships with Jackson Hewitt, Liberty Tax, and many other independent operators. I estimate that RBCAA provided approximately 1 million RALs and 2 million RACs in 2009 (based on information from their public filings). Last tax season, the average sized RAL generated an APR between 100% and 180%.
Earlier in the year, the FDIC issued a cease and desist order to Republic Bank due to its tax business and its “unsafe or unsound banking practices” that “violated federal consumer protection laws.” Last month, in an attempt to appease bank regulators, Republic announced dramatic new pricing for its RAL product. These changes were geared towards improving the “long-term health and viability of the tax refund industry.” For the 2010 tax season, RBCAA has reduced its RAL fee on its average sized loans from $126 to $60. RBCAA’s management expects the new pricing structure to be revenue “neutral” assuming the same volume of returns.
This strategy would be a massive blow to the tax prep companies that rely on Republic. Republic’s goal will be to make up the fee reduction because it “does not expect to share revenue with third parties in connection with the delivery of tax refund products associated with in-person tax preparation services.” This has created a dreadful dilemma for competitors of H&R Block as the source of their profitability may vanish. In previous years, Republic’s RAL fees and RAC fees were split with the tax preparer, resulting in high margin revenue for the tax preparers. In 2010, it is my understanding that Republic Bank will retain THE ENTIRE RAL and RAC fee, thus this profit center disappears for tax preparers.
The situation is even more critical for the largest provider of RALs and RACs, Pacific Capital’s (PCBC) main bank subsidiary, Santa Barbara Bank & Trust. The company disclosed that they processed 5.6 million RACs last tax season (10q, page 19) and I estimate around 3 million RALs. In past years, SBB&T offered RALs at yields similar to Republic Bank (100-180%). This year, a best case scenario for SBB&T’s tax prep clients is that SBB&T reduces its pricing to levels consistent with the rest by the industry—thus cutting a high margin revenue source for tax prep firms. That is the best scenario.
The more likely outcome is that SBB&T will not be able to service any of its 8.4 million returns. PCBC is a California bank with toxic construction and commercial real estate exposure. PCBC currently trades at 27% of book value and its stock is down 92% year-to-date. It is currently operating under a memorandum of understanding from the OCC and the Fed. Under the MOU, PCBC agreed to maintain a minimum Tier 1 leverage ratio of 9.0% by 9/30/09. The Tier 1 leverage ratio was 5.6% at 6/30/09 and additional future losses will continue to drive its capital ratios lower.
To get to a 9% Tier 1 leverage ratio, PCBC needs to raise $275 million to $300 million of equity capital ($8.4 billion tangible assets and $496 million of Tier 1 capital equaled at $288 million capital deficiency at June 30). That compares to a current market cap of $56 million. The capital and equity markets remain somewhat open to bank recapitulations, but there has yet to be one bank that was able to raise 100% of it market cap in a recapitalization. PCBC needs to raise 5 times its market cap.
During the 2008 tax season, SBB&T funded its tax business with $1.3 billion of brokered deposits and a $524 million syndicated bank line. Typically, under a formal MOU, a bank cannot raise brokered deposits. In addition, with a Caa1 debt rating and E+ financial strength rating from Moody’s (MCO), it will be nearly impossible for PCBC to get another syndicated line. With the securitization market currently closed, PCBC has no alternative source of funding its tax business. The sad fact is that unless PCBC is able to pull off the largest bank recapitulation in years, it will likely become a failed bank. Under that scenario, who will be there to fill the void for 8.4 million returns?
A vacuum is being created:
Over ten banks used to provide RAL loans to the tax prep industry. Bank regulators have made it very difficult on these banks--even forcing some banks to exit the tax business altogether. Today, the number of banks providing tax loans is down to four: RBCAA, PCBC, HSBC and JP Morgan (JPM). Three years ago, HSBC was the largest provider of RALs. More recently, HSBC has dramatically reduced their tax exposure, and now is the exclusive provider to H&R Block. JP Morgan also used to be significantly larger in RAL lending but has significantly reduced the size of their business after lowering its rates to 36% APR.
It is my understanding from discussions with industry participants that JPM will continue to reduce exposure to RALs. As a result, I believe there is a vacuum that will be created for the 2010 tax season by Pacific Capital’s potential failure and the changes at Republic Bank. This belief is supported by RBCAA’s drastic pricing change. As “one of a limited number of financial institutions which facilitates the payment of federal and state tax refunds through third party tax-preparers,” the bank can dramatically alter the economic split because the tax prep firms literally have no other alternative.
With No One to Fill the Void on Funding, How bad is it for the “other” prep companies?
Many tax preparation firms “live by the RAL”, but unfortunately this year, many will “die by the RAL.” In response to Republic’s price cuts, I believe tax preparation firms will attempt to charge their own RAL fees or will be forced to increase their tax preparation fees. However, firms will be limited in their ability to charge additional RAL fees. It is my understanding that Republic must operate under Kentucky usury law (under 30% APR) as a result of its cease and desist from the FDIC (the bank cannot access its federal saving charter to bypass state usury).
If this is the case, it will limit tax prep firm’s ability to charge additional fees (that would drive the APR higher, violating state usury laws). As a result, tax preparation firms will be forced to increase their standard tax preparation fees as a way to recoup the RAL losses. To fill the high margin revenue hole, tax firms may have to raise prices by 25% to 35%. These price hikes at other tax preparers should be a significant benefit to HRB because of its minor RAL exposure, stable relationship with HSBC, and its massive scale.
Firms with large franchise operations, like Jackson Hewitt and Liberty Tax, are in a difficult situation. For example, Jackson Hewitt retains 100% of the RAL / RAC fees but only collects 20% of tax preparation fees from its franchisees in the form of royalty payments. To replace the earnings of a RAL for the parent company, JTX’s franchisee would have to raise prices by $150—which would price them out of nearly every market. At a bare minimum, it is going to be almost impossible for JTX to fill this profit hole. Given its debt load and restrictive covenants, the company does not have much wiggle room even with a solid tax season.
JTX had $232 million of debt at 6/30/09 and requires additional debt during the early tax season that could peak around $350 million by January 2010 (debt was $356 million at 1/31/09). Analysts are currently forecasting $70.9 million of EBITDA in 2010, suggesting only $300 million dollars of debt capacity relative to its 4.25 debt to EBITDA covenant (calculated with average LTM debt and LTM EBITDA) and $296 mm of current average debt. (10k). Incredibly, analyst estimates do not include ANY impact related to Republic Bank or Santa Barbara Bank & Trust. Yet the impact is massive. For example, if JTX lost 25% of its financial services revenue, the impact to EBITDA would be $11 million, which would cause its leverage to shoot up to 5.0 times. If it loses 100%, its leverage will increase to greater than 11 times. Under these scenarios, JTX will be in violation of their debt covenants and potentially have significant cash flow problems. As a result, I believe the company will be unable to pay off their $25 million debt payment due April 2010. Unless JTX can figure out how to rapidly rewrite its franchise agreements or totally alter its economic profile, it will be difficult for JTX to avoid bankruptcy.
I cannot overstate the devastation the industry will likely face from PCBC’s likely inability to fund RALs/RACs in 2010. Jackson Hewitt and Liberty Tax may not be able to offer one of the most important products to tax filers as they make their decisions on who to hire for tax prep. A common oversight by Wall Street has been focusing on HRB vs. JTX, yet missing the fact there are thousands of other tax preparers that will likely cede ground to H&R Block. HRB may be the only firm with capacity to provide these products. Liberty Tax appears to be trying to address the issue. Last month Liberty Tax’s parent company, JTH Tax, offered to buy a tiny $90 million asset bank from a bankrupt company. Regulatory approval will be difficult and the bank will not be able to help Liberty this tax season, but at least Liberty is trying to address their long-term future. Even the volume of digital tax returns could be impacted. Intuit’s (NASDAQ: INTU) TurboTax is a large client of Santa Barbara Bank & Trust.
HRB has a wide open shot on goal that investors have yet to understand
Republic Bank and Santa Barbara Bank & Trust touched over 11 million tax returns last year. Their tax preparation clients filed a far higher number of tax returns (I estimate at least 15 million). I believe widespread price increases and the lack of availability of financial services products will have many of these retail clients looking for a new tax preparer this year. With H&R Block’s brand name, competitive pricing, and breadth of locations, they should be the main beneficiary. If H&R Block can pick up even a small part of this disrupted market, it will have its best tax season in years. For every 1 million new retail clients that HRB can add, the tax service business should grow by an incremental 600 basis points. What will be more compelling for analysts and other investors is that the same 1 million new clients will be roughly $0.25 accretive to earnings ($190 per return at a 60% incremental margin plus a small attachment rate for RALs and RACs). This impact will drive significant upside to current consensus estimates of $1.62.
And if it couldn’t get any better for HRB….
The market share gains from the disruption in the RAL/RAC market represent the most important near-term catalyst for HRB shares. But it gets better. One current overhang for the stock is the dispute between RSM McGladrey and its JV partner McGladrey Pullen. As a result of the dispute, HRB’s management has taken a very conservative stance towards their share repurchase plan (given the likely chance that management has material non-public information in regards to discussions with M&P). The largest potential benefit to putting the M&P dispute behind the company will be the resumption of their $2 billion share authorization. HRB currently has $1.9 billion remaining on its authorization. I expect a settlement could occur at the same time the competitive landscape is ripe for improvement.
HRB’s subprime mortgage exposure has been another major drag on the company over the past three years. However, as the stars align, this is a drag that may actually turn into a benefit. At $707 million, mortgage portfolio is half the size it was a few years ago. The loans are mostly 2005 and 2006 vintage, which means they are seasoned loans and past the two year reset window (and peak delinquency). HRB’s 11.6% loan loss reserve is one of the highest of any bank in the U.S. and its $63 million provision in fiscal 2009 was a $0.12 drag on earnings. This drag to earnings may reverse in the next twelve months as HRB no longer is forced to take incremental provisions. This fact is another material positive that has been ignored by the sell side as it relates to HRB, despite being a major driver for higher stock prices of many pure play banks.
Earnings Power and Valuation
The most interesting dynamic for the RAL / bank disruption is that Wall Street analysts and investors are totally oblivious to this dynamic and the magnitude of opportunity it has created for HRB. Shockingly, on 10/26/09 Morgan Stanley downgraded HRB because it was “vulnerable to intense competition” and the analyst stated that “competitive pressures [could] grow” in 2010” The analyst also opined that the stock was “somewhat expensive” at 5.5x EBITDA and 12x the analyst’s street low EPS estimate. I am quite confident that the exact opposite could be true this year, which would create the holy grail of positive surprises. Since RBCAA and PCBC are small cap banks with little research coverage, I believe their large impact on this year’s tax season has largely gone unnoticed.
HRB has all the characteristics of what investors, large and small, look for. HRB is leveraged to increased tax complexity, fueled in part by additional tax credits to spur economic growth, and a future rebound in employment. Its stable 3.3% dividend offers a bird-in-hand return. The sentiment of the 7 analysts (5 sells and neutral ratings versus only 2 buys) could swing dramatically as my catalysts materialize. Finally, expectations remain very low. Management’s 2010 guidance is $1.60 to $1.80 per share with tax revenue up low single digits. The current consensus estimates are at the low end of management’s outlook: $1.62 EPS and flat year-over-year revenue.
Even small market share gains relating the RAL / RAC issues are likely to drive guidance and estimates much higher in early 2010. In addition, utilizing just one-fourth of their share reauthorization adds an incremental $0.10 per share (not included in guidance). Including the reduced drag from subprime provisions, HRB could experience powerful earnings leverage in 2010 and 2011. As investors and sell side analysts recognize HRB has $2.00 of earnings power over the next 12 months, shares of HRB will trade north of $30 per share by early tax season (mid January / early February). As I said, the stars are aligning beautifully for one of America’s most recognized brands.