H&R Block: A Better Investment Than You Might Think

Over the past few years H&R Block’s stock (HRB) has taken a beating. This has been due mostly to increasing competition and HRB’s own missteps. HRB’s core tax preparation business has been under pressure from DIY tax software, specifically Intuit’s TurboTax. Likely in response to its eroding position, HRB moved into the mortgage and financial planning and investment products markets. Both moves turned out to be disastrous, with HRB getting caught in the subprime mess and selling its mortgage unit. The financial planning business also ended poorly with a flurry of lawsuits and the business being sold to Ameriprise. In 2007 after a proxy battle by Richard C. Breeden, a hedge fund manager and former SEC chairman, the previous CEO resigned. Former McDonald’s executive Russell P. Smyth was brought in. With all of the previous troubles it’s no surprise HRB trades very cheaply at 12 times earnings and a dividend yield of over 3%. Warren Buffett is famous for saying current investors don’t profit from past growth. In HRB’s case current investors won’t get hurt by past mistakes. So let’s look at what the future for HRB might hold.

The big issue in most investor’s minds is what effect software tax prep programs will have on HRB. Most frame the argument this way: An increase in the use of software tax prep programs will lead to lost business at HRB.

Missing from consideration are two important points.

First, HRB offers its own software product, H&R Block at Home (previously called Tax Cut). So an increase in the use of DIY software does not necessarily translate into a loss of business for HRB.  Currently H&R Block at Home has roughly 20% of the software market versus TurboTax’s 80% market share.

Second, while the market for DIY software may be growing, it will not grow to encompass the entire tax prep market. There will always be a large number of people who are either unable or unwilling to do their own taxes. When you look at the numbers for 2008 to 2009, you see that the DIY market is growing very slowly. Over that time period it increased by only one half of one percentage point. As it currently stands TurboTax is gaining market share from people who have previously done their taxes themselves with no software to assist them. HRB has been losing a majority of its market share to other assisted tax preparers such as local accountants, not to TurboTax. This also jives with my conversations with other independent tax preparers who have not seen any noticeable drops in their business due to DIY software.

HRB possesses some unique advantages beyond its well-known brand name. HRB can offer refund anticipation loans, although now the IRS is offering refunds quicker. HRB offers broader guarantees of correct filing than DIY software vendors and gives more assistance in the event of an audit. HRB also has the ability to potentially tie some or all of those services into its software product as well. HRB also has a small relatively unknown business, accounting, and tax consulting arm in RSM McGladrey. While the consulting industry is brutally competitive due to low barriers of entry, it is a phenomenally profitable one. An increased focus by HRB on growing this business unit would add to its bottom line.

The main rival to HRB is Jackson-Hewitt (JTX), which right now is heading towards possible bankruptcy. In any case the continued trouble at JTX bodes well for HRB as the consumers who use JTX are likely to be the same demographic that would utilize HRB.

In summary, the pressure HRB is facing in the marketplace is primarily on the top line. The underlying business remains excellent. The company has consistently posted both ROE and Cash Return on Invested Capital of above 20%. The company has a strong balance sheet with over $1.7B in cash compared to $1.1B in long-term debt.

At its current valuation, the market is basically pricing in the assumption HRB will continue to see earnings and free cash flow decline, with free cash flow declining at double digit rates. While HRB may be under pressure, there are several plausible scenarios detailed above in which HRB grows or at least generates stable profits. This is a classic case of buying a company that the market expects to do absolutely awful and a shareholder can be rewarded (possibly even handsomely) by a return to mediocrity. In my view most of the downside has already been priced out of HRB.

Notice: Investing in stocks contains risks; you may lose all of your money.

Disclosure: My clients owned shares of H&R Block (HRB) at the time of this writing although positions may change at any time.