Value investors typically look for bargains in either cheap assets or cheap cash flows. Stocks are rarely bargains when a company is prosperous and everyone loves it. Bargains are most often found under a cloud. And there are certainly clouds hanging over H&R Block (HRB) these days. Because investment returns are simply a function of what you pay versus what you receive, the drop in price at the end of February prompted another look.
Like many investors, I followed H&R Block for years as their network of company-owned and franchised locations grew across the U.S. Block’s leading market position, strong brand name and low capital requirements made it an attractive free cash flow generator with high returns on capital. Unfortunately, Block became heavily involved in subprime mortgage lending through its Option One subsidiary at exactly the wrong time. The mortgage losses began eating up all of the free cash flow from the core tax preparation business. Within the past couple years, Block has discontinued the mortgage origination business and sold its financial advisory business in order to return focus to its core tax prep business.
While Block still holds a substantial mortgage portfolio (most of which it purchased from Option One/Sand Canyon), its loss exposure is now at a manageable level. As of January 31, 2010, outstanding principal balance stood at about $733 million. About $465 million of this amount was subprime loans from Option One/Sand Canyon. The remaining $267 million was purchased from other sources and is generally considered prime. Loan loss allowance totaled $97 million, or 13% of the principal amount. This loss allowance is based on 27% of the loan amounts being 30+ days past due. This works out to about a 50% loss severity assumption on all 30+ days past due loans, which is fairly conservative. Even assuming a 50% default rate and a 50% average loss severity, losses would roughly double the current loss allowance of $97 million, which is quite manageable for a company that generated about $900 million in free cash flow in fiscal 2009.
Another lingering concern is the deterioration of Block’s core retail tax preparation business. There is a possibility that the rate of expected deterioration is too high. Block filed 24.0 million returns in fiscal 2007 (21.5 million in U.S.), 24.6 million in 2008 (21.8 million in U.S.) and 24.0 million in 2009 (21.1 million in U.S.). These results are relatively flat, so factoring in a modest mid-single digit decline seems conservative.
Investors appear to be worried about the growing use of cheaper (and sometimes free), electronic, do-it-yourself tax preparation software. While Block dominates the retail do-it-for-me space, Intuit (INTU) clearly dominates the digital space. Although the trend towards digital tax prep is expected to increase, there are a couple of factors that may limit its use. First, some people are intimidated and/or bothered by numbers and taxes, and feel more comfortable having someone else do it for them. Second, Block offers a competing product. Block’s digital tax filings grew from 5.7 million in 2007 to 6.0 million in 2009, including online filings growing from 1.7 million in 2007 to 2.8 million in 2009.
The other concern that investors often have relates to Refund Anticipation Loans, or RALs. These loans are often subject to much negative publicity over high fees. RALs and similar products accounted for less than 4% of Block’s fiscal 2009 revenue. The number of Block filers using these products has gone down from 3.9 million in 2007 to 2.9 million in 2009. In other words, it would not be a terrible blow to Block’s business if RALs completely disappeared. On the positive side of the RAL issue, Block has been successful in securing RAL funding, while its main RAL competitor, Jackson Hewitt (JTX), has not.
H&R Block expects total IRS filings to decline 2.5% to 3.5% in 2010. This accompanied by an increase it digital filings (some of which will be lost to Intuit), could lead to top-line declines of 5% to 10%. However, potentially offsetting this decline could be an increase in average retail tax prep fee. Block has shown the ability to do this before, increasing its average fee per return filed from $165 in 2007, to $175 in 2008, to $187 in 2009. Similar increases should help stabilize Block’s top line. In addition, Block could easily cut its largest costs (occupancy and compensation) by consolidating underperforming offices, should the retail format continue to decline.
The last major concern is the same concern that has always existed in the tax prep business. Customer revenues are highly seasonal and generally only recur once per year, making year-to-year visibility difficult (although no more difficult than recurring revenue cycles for most goods and services). Offsetting this is the fact that most people must file taxes on a predictable schedule.
As with any investment, there are always going to be risks. Investing is a matter of eliminating the unacceptable risks and then handicapping the acceptable risks. With a respectable balance sheet and the subprime mortgage mess behind it, H&R Block should produce a generous stream of free cash flows well into the future—even if retail filings continue to decline. Investors may want to consider a small entry position at current price levels with an eye to average down under $15 per share. In the meantime, investors can collect a 3.5% dividend yield for their patience.
Disclosure: I do not currently own shares of HRB, but have recommended it to subscribers of IgnoreTheMarket.com.