I found H&R Block (HRB) in the same way that I find many companies: through my screening of Value Line. This was similar to Aeropostale (ARO), in that the stock price was too high when I read the VL report, but it fell considerably since then. H&R Block is a business that Buffett has put money into in the past. Given the underlying fundamentals, I’m not surprised by this in the slightest; it really is a great company.
H&R Block, if you’re not already intimately familiar, is a business whose core competence is providing tax return services to millions of Americans every year. This business was originally started by the Bloch brothers, Henry and Richard, when the IRS stopped offering free tax return services in 1955. The Blochs had already spent time trying to set up a business as accountants to provide tax services for small businesses. Once the IRS stopped offering their services, it was easy for the Blochs to switch gears and solely focus on preparing individual tax returns. Over the years, the company built up its dominance in the field and became the leading tax-return filer for the United States. One of the original brothers, Henry Bloch, remained at the helm of the company until 2000, when he resigned as Chairman of the Board.
A few years before Henry’s resignation, in 1997, the company had finally decided to expand their business model from being only tax return advisors and moved away from their core competence to becoming the place to go for all financial services and advice. They acquired Option One Mortgage and started Block Financial Advisers to diversify their business model and allow for future growth. This was a move from only being tax return advisors to being the one-stop shop for all financial advice. If you take a look at HRB’s financials from 1997-2010, you will clearly see a boom and bust cycle that mirrors the mortgage industry. At the peak in 2007, HRB held a large amount of mortgages on their balance sheet. Many write-offs and losses followed. 2007 was the first time in the company’s entire history since 1955 that they posted a net loss. They posted a loss again in 2008. This should give you a picture of how much management had gotten outside the core competence of the business; the tax return business remained relatively consistent through the recession, and yet, the company posted large losses.
Since then, H&R Block’s management finally decided to focus again on their core business of providing tax return services. Block Financial Advisors was discontinued and written off against income. They attempted to sell Option One to Cerberus Capital Management, but the deal fell through and the business was shut down entirely. With all this bad history from the last decade behind them, management has decided to once again focus on providing tax return services. When I first started reading through the annual reports, I was hoping that management had decided to completely stop with the mortgage nonsense. With that assurance, I moved forward to really dig and figure out what I could.
The first thing that struck me was the VL page. At a quick glance, I could tell that the business requires very little capital to operate, had a manageable debt load, posted very consistent margins, and had very efficient assets over the last decade:
- Return on deployed capital: average about 150-200% ($1.50-$2 returned every year for each $1 in working capital)
- Debt paid down in less than 2 years of earnings
- 23-26% consistent operating margins
- 22% average return on assets
This showed me it had the type of business that I am looking for. Unfortunately, all of their excess cash flow after capital expenditures is being used for dividends or share buybacks. This means that, although those 22% returns on assets are great, you as an owner cannot expect the business to find returns like that any more. The tax-return business is now mature, and has been for some time.
I then began reading over the various SEC filings, trying to determine the various business segments and the how they make their money. Their business is separated into tax services, business services, and corporate operations. “Tax Services” is by far the largest segment of the business (75% of revenues) and is where the great business lies. Two thirds of this segment is made up of their retail tax return business, and one third is made up of various products and guarantees offered to their clients. If you’re really interested, I’d tell you to look further into it for yourself. Tax Services has had one issue in the past few months- the IRS has come out and said that since they process all tax returns quickly (I’m guessing it is not all electronic or they are just very efficient), they will no longer be releasing tax indicators to H&R Block on how much the client will be receiving in returns ahead of time. The IRS’s argument is that it only takes two weeks to receive your check from them and there is no reason to spend time letting H&R Block know how much the client will actually receive. This doesn’t sound like a big deal, but H&R Block has an agreement with HSBC Bank to extend either a loan (RAL) or a check (RAC) to the client on the day they file their tax return. This allows the customer to receive their tax return the day they file it if they choose, rather than wait for the IRS to send it two weeks later.
H&R Block has been charging commissions on this and HSBC (HBC) has been charging loan-shark type interest for providing this service. The recent Frank-Dodd Bill will not allow interest rates as high as what they were charging, seeing as they are considered predatory. HSBC has been warned by the government, and after the IRS stopped sending in these tax indicators, HSBC would have much greater risk for determining the actual money coming back from the IRS that is used to pay back the check/loan. Therefore, HSBC dropped the service a year before the contract with HRB expired and HRB immediately filed a lawsuit. Because of this lost contract & fees, the Tax Services segment will lose about $170 MM of its earning power. Also in a similar realm with the Frank-Dodd Bill, H&R Block also offers an Emerald Advance Card that charges 35% interest on it. This will not be allowed in the same way that the HSBC agreement worked, so HRB will lose about another $80 MM from not being able to provide this service in the future. So, with an average earning power of about $850 MM last few years, if you subtract out these lost products, you’d end up with about $600 MM. This is the most consistent part of the business and can be relied on for being there into the future.
Intuit’s (INTU) Turbotax is the only real threat to the Tax Services segment, but Intuit’s services are targeted more toward people willing to take the time to do their own taxes. H&R Block believes that there will continue to be demand for their retail outlets and face-to-face interaction. In addition, H&R Block has attempted to make a few strategic acquisitions to counter TurboTax in the digital arena, but it will be very difficult to make any headway in this market. I’m just hoping they don’t overpay in hopes that throwing money at a problem will inevitably fix it.
The other profitable part of H&R Block is their Business Services segment. This is made up of RSM McGladrey Inc and they provide tax and consulting services to small & medium sized businesses. Their earnings make up the remainder of HRB’s profitability at 25% of their business. Management has stated that they like the growth prospects for this segment, but I am not seeing this in the figures. To be conservative, I’ll treat this segment as a mature business as well. So, I am assuming that H&R Block is fully mature when making my final valuation. In terms of profitability for this segment, the business can reasonably be expected at about $80 MM. I have nothing else to say about this segment- there are no major changes the way there are with the Tax Services & HSBC/Dodd-Frank Bill.
The final segment is Corporate Operations. This is made up mainly of mortgage loans held for investment and interest-bearing securities. All of these operations created speculative earnings for shareholders over the last decade as the mortgage bubble grew and H&R Block got caught up in this cycle like everyone else. This segment has posted losses the last 3 years due to large write-offs with mortgages. At the peak of the 2007 bubble, HRB held $1.6 B in mortgages, many of them toxic. Since 2007, the company has unwound many of their positions down to about $550 MM today. Of these current mortgages, about $320 MM are underperforming. Management has stated its commitment to winding down this entire mortgage portfolio and not entering into this any more in the future.
The debt schedule for HRB moving forward is $600 MM due in 2013 and $400 MM due in 2014. Other major concerns would be further losses in the mortgage portfolio, so I decided to be as conservative as possible and write-off the whole $550 MM yesterday against earnings. Therefore, HRB owes $55o MM in 2011 for 100% losses in mortgage portfolio (far too conservative for reality), $600 MM in 2013, and $400 MM in 2014. The current earning power of Tax Services is at $600 MM and Business Services is about $80 MM. H&R Block can reasonably expect earnings around $680 MM moving forward. This can easily cover their debt schedule and all mortgage losses. Do not ignore this fact; all downside risk is covered within the company. There is still the risk of increased competition and it is something you must keep a close eye on, but the business is at a very low risk for imploding on itself.
For valuation, this company is best valued as a mature business. Normally, I would use free cash flow, but for HRB having many mortgage losses & other write-offs, I decided to use my estimates of what the underlying business will earn in the future. Therefore, we should use the $680 MM from the two business segments and subtract out some of those mortgage losses the next few years. I figure, to be conservative considering further possible losses with mortgages, we should estimate roughly at $600 MM for the next 3 years and value the company accordingly. For mature companies, I demand a 20% initial return that I can reasonably expect to continue to be earned by my business as an owner. Therefore, to get a 20% return on $600 MM earnings each year, I’d want to pay about $3 B. If you look at how the company is allocating earnings, it is almost all going into dividends and stock buybacks. This is not a recipe for growth, only a way to distribute earnings to owners - this is why I demand 20% on my money.
Also something to consider are the recent shifts in executive management. The CEO, CFO, and President of one of their divisions all recently quit/were fired. H&R Block has yet to have a consistent CEO since 2000, when Henry Bloch retired. I have trouble putting my money behind an untested and unknown management team, so I decided to pass on this investment when I first completed my research and HRB was selling at about $3.1 B. This would have lead to a 19% return, but with untested management skill recent shifts in corporate governance after receiving criticism, I decided to wait. I did not attempt to predict where the stock was headed, I just figured I would buy if I could get a better initial return on my money considering the risks behind management, TurboTax, and their mortgage portfolio. This company came close to my purchase price and I sat on my hands. Hopefully, I don’t regret it moving forward.