H&R Block's Focused Business Warrants Higher Valuation

| About: H&R Block (HRB)
This article is now exclusive for PRO subscribers.


H&R Block has become a pure-play on prepared tax returns in recent years.

While the company failed to grow topline sales, share repurchases have created value for investors.

A focus on the core and appealing valuation, outweigh the impact of a somewhat leveraged balance sheet and poor growth track record.

H&R Block (NYSE:HRB) is the largest tax service provider which has turned itself into a pure play in recent years.

The company prepared over 24 million tax returns in its fiscal year of 2014, generating $3.0 billion in revenues. This translates into average revenues of $125 per tax return, yet it was certainly worthwhile for its average customer. In total, H&R claims that its clients obtained more than $50 billion in refunds, credits and benefits, for an average of little over $2,000 per return.

A Focus On The Core

The last decade has been kind of sloppy for H&R Block. The company has been a target of activist investors, while management turnover was very high. No less than 4 different CEOs were leading the company in the period 2007-2011.

Under the current leadership, the company has rapidly increased its focus on the core tax preparation businesses. This meant exiting the mortgage and banking activities, while the company introduced new products such as the "New tax plus" strategy in order to be busier during the non-tax season.

New products include the provision of credit ahead of tax returns, Emerald debit cards, as well as after-tax services. While it is very lucrative for H&R Block to service its customers through its professionals, it offers (online) services for do-it-yourself customers as well. The company remains very much leveraged to the US. The vast majority of the 24 million tax preparations are done in the US. Canada is good for some 2.7 million filing and Australia for another 0.8 million filings per annum.

This more simple structure and exit of capital-intensive banking businesses freed up a low of cash. This cash has largely been used to buy back shares. The company bought back over 76 million shares since 2011 at an average price of little over $26 per share. Painful have been the 40 million shares which have been bought back at $37 per share last summer. These "rushed" buybacks, following the divestiture of the banking activities, have been executed at high prices and have leveraged up the balance sheet.

The company believes that the tax-preparation business continues to see a bright long term future. The increased complexity of the tax code, additional complexity from the Affordable Care Act, and increased crackdown on fraud, should all drive this growth.

As always, tax preparation is a very seasonable business. In January and February there is an early season peak, followed by a greater peak at the end of April as the season is ending.

The Transformation Still Has To Prove Itself

The focus to become a pure-tax preparer has resulted in some lost revenues. The company posted sales of $4.9 billion in 2006, a number which has fallen towards $2.9 billion in 2012/2013. Revenues have been largely stable ever since, coming in just above the $3 billion mark at the moment.

While this look very unsatisfactory, the increased focus allowed for operating margins to rise from their high-teens in 2006, towards 25% for the fiscal year of 2015. Even better, a lot of capital has been released, allowing for sizable share buybacks. The outstanding share base has been reduced from 334 million shares in 2006 towards 224 million at the moment, marking a reduction in the outstanding float by roughly a third.

The share price has kept reasonable track with the earnings per share developments. Shares traded around $20 in 2006, only to fall to $10 in the years thereafter as the diversified strategy was not working. The pure-focus strategy led to a recovery towards a $25-$35 trading range since 2013. At the moment shares have fallen towards the lower end of the range following recent disappointments.

What Is The Problem?

Until the autumn of 2015, nothing was going wrong, at least for the shareholders in H&R Block. The divestiture of the bank activities, and share repurchases which followed, have pushed shares to a level of $37 per share, accompanied by a decent dividend. A weaker second quarter, but notably the third quarter results in early March put significant pressure on the shares. At the moment shares have fallen towards the $26 mark, translating into a 25-30% retreat from recent highs.

Third quarter revenues, as reported early in March, fell by nearly 7% to $475 million. Part of this relates to the divestiture of the bank activities, while the strong dollar had a limited impact as well. The real issue is that the company saw weakness in tax preparation volumes. The good news is that part of this results from a trend towards later filings, suggesting that part of these revenues could be caught up with.

What is worse is the impact of these revenue declines on the bottom line. A $34 million reduction in revenues resulted in net losses increasing by $44 million to $79 million. Part of the increase in losses was the result of the increase in leverage being taken on by the company.

Buybacks continued and reduced the outstanding share base to 224 million shares. The more stable business model allows for an increase in leverage, as management was eager to benefit from the lower share price as well. At the moment, H&R Block holds merely $260 million in cash and equivalents while the debt load has risen towards $2.6 billion, for a net debt load of $2.3 billion.

What About The Tax Season?

H&R Block posted a loss of $81 million for the first three quarters of the year, up from $37 million in the corresponding period a year earlier. All of this was ahead of the key tax season which corresponds to the fourth quarter of the company's fiscal year.

These results are pretty meaningless as all of the company's profits and roughly 75% of sales are generated in the fiscal fourth quarter. Last year, the company posted annual sales of roughly $3.0 billion, (of which $2.3 billion in the fourth quarter), while full year earnings amounted to $473 million and adjusted EBITDA totaled $950 million.

While the company is behind schedule in the third quarter, it is not unthinkable to repeat last year's full year results. Based on 224 million shares, earnings could come in at roughly $2.00 per share, implying a merely 13 times earnings multiple. Even if the results are not attainable, the multiple seems to be quite appealing.

This is not very high for a stable margin and revenue business. The net debt load of $2.3 billion is somewhat elevated due to continued share buybacks, as leverage is seen around 2.5 times adjusted EBITDA. As the strong fourth quarter cash flows are currently coming in, the leverage ratio is likely to fall significantly in the coming quarter.

Final Thoughts

I think that H&R Block has made the right strategic moves and benefits from long term favorable trends, including the continued complexity of the tax code and crackdown on fraud. Worrying are the trends of do-it-yourself as sophisticated software packages which could offset the continued increase in complexity of the tax code.

The trouble is that the company relies more heavily on the tax strategy following the strategy to become a pure-play. This creates a lot of earnings volatility, something which investors generally do not like.

This volatility and the somewhat elevated leverage ratio are both small concerns of mine, certainly as these buybacks have been ill-timed. That being said, a 25-30% decline from last year's high is sizable for a generally stable business, even as leverage is on the higher side. If earnings of $2.00 per share are reasonably within reach, (either this year, or next year) I see no reason why shares could not recover to a range of $30-35 per share following the fourth quarter.

Disclosure: I am/we are long HRB.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.