Monday, October 25, 2010

H&R Block Looks Attractive

H&R Block (HRB) makes about $500 million per year in net income, mostly by providing face-to-face tax services to individuals. But for several reasons, most of which are either immaterial or short-term in nature, it trades for just $3.3 billion, giving it a P/E of just 7. For long-term value investors, this may be an excellent entry point.

First, let's look at some of the risks facing this company:

1) Mortgage Put-Backs

The most immediate market fear with respect to this company is the same one facing many US financials today. During the housing bubble, Block used to originate mortgages. (It has since divested that operation.) Buyers of those bad mortgages (of which over $30 billion remain outstanding, down from $50 billion two years ago) can force Block to pay penalties or buy back mortgages where it can be proved that Block has made "valid breaches of representations and warranties".

The company originally set aside $243 million for this purpose, of which it has paid $55 million over the last two years based on a case-by-case examination of the loan documents. Recently, management has re-iterated that it is comfortable that the remaining $188 million reserve will cover future put-backs. But even if one doubles, triples or quadruples this reserve, it still doesn't justify the $4 billion in market cap this company has lost in the last few months!

2) Regulation

Another issue facing this company is the fact that governments don't like some of the services Block provides and has sought ways to curb them. Block has settled many of the lawsuits it has faced, however, some remain outstanding. But the problem isn't just restricted to lawsuits. Recently, the IRS announced that it would be withholding key credit information about filers, which will make it harder for Block to provide loans to some of its clients. We've seen this issue of government interference before with another extremely cheap stock, but in Block's case, its regulatory-friendly services are worth way more than its peripherals. For example, Block stated that the credit information withholding by the IRS is likely to cost earnings about 5 cents per share this year.

3) Do-It-Yourself Online Filing

The main long-term issue facing this company is the fact that over time, tax filers are shifting online and away from bricks and mortar companies. Intuit (INTU) has been successful in growing the use of its Turbo Tax software, and Block's software unit has not been able to keep pace. But due to changes in the last couple of months (discussed below), Block may actually have a bright future in this area.

This brings us to the end of the section on risks. Now for the positives affecting this company:

1) Do-It-Yourself Online Filing

Two weeks ago, Block announced that it has merged with the company that produces TaxACT, tax filing software that 5 million Americans used last year to file returns. The entrepreneur who started that company in 1998 and has been leading it since will now head Block's digital business unit, with a separate P&L. Where Block couldn't succeed on its own, it has acquired capable management that can.

2) Weak Bricks & Mortar Competition

While the recession has taken a bite out of H&R Block, it has taken an even bigger bite out of the competition. The next largest retail filer, Jackson Hewitt (JTX), is having trouble just staying solvent. Its current ratio is well below 1, its debt levels relative to income are very high, and it continues to shut locations, which should allow Block to increase share. Block's net debt level is only about half of one year's worth of net income.

3) Free Mortgage Assets

The market is sour on the mortgage market, but Block continues to receive cash from mortgage assets that it owns itself (not to be confused with mortgages it has sold, as per risk #1). It owns over $550 million of mortgages, after allowances for impairment, that the investor is getting absolutely free at the current stock price. Cash flows from these assets can no doubt help cover shortfalls that may occur with respect to risk #1.

4) Shareholder Friendly

This company returns cash to shareholders. The dividend yield is almost 6%, and the company has bought back $400 million worth of shares in the last year. This is a signal that management doesn't just say that its put-back reserves are adequate; its actions suggest that it truly believes it. The chairman of the board of directors owns $130 million worth of the company.

5) Potential For Services Growth

Block is able to use its retail presence to introduce and further grow client services other than tax filings. One area that is particularly ripe for growth according to management is the company's debit card program, which is providing debit services to tax clients who do not have bank accounts.

Block's stock price has not been this low since 2001. Because sentiment in the mortgage space is so poor, investors are perhaps being offered the opportunity to buy a strong franchise at a terrific price.

Disclosure: Author has a long position in shares of HRB

13 comments:

Paul said...

Bill Nygren, the manager at Oakmark, also owns a big piece of HRB. His fund, OAKLX, has almost 4%of it's assets in HRB. Nygren is certainly one of the best out there. He's held it for quite a while though.

Red Rock said...

Barel,

Do you know what percentage of the mortgages they have written have been "put back" so far? It's now looking that huge percentages of mortgages written in the mid 2000s have problems with them, so if just 20% of the 30B mortgages sold are put back, the company may be bankrupt. I wouldn't rely on management's guess. The same thing is going on at BAC.

Saj Karsan said...

Hi Red Rock,

They have received $700 million worth of claims over the last 27 months, with 2/3 occurring in the first half of the last 27 months. They have paid $55 million so far to settle over $500 million of those claims worth $700 million.

Even if you assume you can prove H&R misrepresented facts to such an extent that there are claims on 20% out of their outstanding sold mortgages (which would suggest a pervasively poor control process at the company), you should be careful not to assume the properties are worth 0 and that the payments have to be made immediately. At the rate they have been paying so far, they would have to pay about $600 million under your pessimistic scenario (10% of 20% of $30B), which is just over a year's worth of earnings. Meanwhile, the stock has been punished by $4B this year.

Anonymous said...

Saj,

It's no longer just a question of whether the mortgages are under water or not. I assume you're familiar with what's going on at BAC and others where loan documents were forged, lost, unsigned etc on a truly massive scale. BAC may not even be able to foreclose on these loans and the mortgage pools these loans were sold to are catching on. Lawyers and states attorneys general are just now beginning class actions suits. Do you have any reason to believe that HRB's loan origination program was significantly better both in terms of quality of the loans and perhaps even more important the quality of the loan documentation?

Paul said...

saj,

your legend is starting to grow. I saw that someone posted your HRB analysis on a forum I frequent. :)

Saj Karsan said...

Good to hear, Paul!

Hi Anon,

HRB's situation is not nearly as bad as that of BAC. Countrywide (now owned by BAC) was the worst offender, and was able to grow its market share in this manner. HRB's share is tiny, and its business is not nearly as reliant on origination as are financial institutions.

Assuming that all companies are as bad as the worst offender can lead to irrational fear, like saying all energy companies in 2001 were accounting fraudulently like Enron.

Justin S. said...

Saj,

You didn't mention the issue between them and HSBC concerning the RAL loans. I view this as more of a reason why the stock is down more than anything. This is an important risk. I haven't been able to find out why HSBC hasn't started it's preparatory actions for the RALs. Do you know why they do not want to offer financing? Jackson Hewitt is in the same boat - they weren't able to secure funding.

Do they fear regulatory backlash?

I don't get it. Customers want this service. It seems like good business for everyone. A lot of these customers are the tax payers who get way more than what they put in (ie EIC) so they have no qualms about forgoing some of this money when they never really earned it in the first place.

Justin

Justin S. said...

Ok, I got it. You alluded to it in your risk section.

Specifically, "HSBC told Block it could not provide funding for the RALs and refund anticipation checks because the IRS has decided to stop providing a debt indicator next tax season that would say whether a taxpayer has liens outstanding, and that would make the loans too risky to provide. HSBC has been in the process of withdrawing from the RAL business since 2007 and Block is its only remaining customer."

from:
http://www.webcpa.com/news/Block-Sues-HSBC-RALs-56026-1.html

Philbert said...

So what about this?

http://www.marketwire.com/press-release/HSBC-Terminates-Agreement-to-Provide-RALs-at-Direction-of-OCC-NYSE-HRB-1373754.htm

Saj Karsan said...

Hi Philbert,

This is likely to affect earnings by a few cents per share this year, but doesn't change anything for the long-term, which is the basis on which I invest.

Philbert said...

Good to hear.

tscott said...

do we have any more colour on the importance of the RAL on customer traffic and earnings. I keep hearing you mention a few cents but is that just a management one liner or have you dug deeper?

tscott said...

So a max impact of 20 cents after tax assuming the segment's earnings go to 0. And that is only for one year. Although they do have some other marketing tools that they could use to offset the loss.

What is more interesting is Jackson Hewitt's success in securing RAL financing.

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