I do not normally analyze large capitalization stocks. I assume that a well-followed stock with a large number of analysts will be trading close to its intrinsic value, and my typical stock screens exclude large cap stocks. However, as part of the background industry research I do with mid-to-small cap stocks, I occasionally come upon large cap stocks which seem attractive to me. In this case, I was researching JTX when I noticed that, on a risk-adjusted basis, HRB presents a much better investment. Below, I describe a rough analysis and valuation of HRB that suggests that it is substantially undervalued.
Why is HRB so cheap? Firstly, its disastrous foray into mortgages in the pursuit of growth has saddled it with 2 albatrosses: a $595M mortgage loan portfolio which is likely overvalued, and a $188M loss reserve from possible put-backs of securitized mortgages from its previous mortgage subsidiary. Secondly, continued turmoil in the refund anticipation loan (RAL) market has heaped further negativity on the stock. The IRS has recently stopped the practice of communicating the likelihood of a refund electronically to tax preparers, which increases the risk of the RALs, and has signaled the intention of discouraging tax filers from utilizing such loans, given that a refund is usually issued as early as 10 days after filing. This was followed late last week with the news of the OCC forbidding HRB’s RAL partner, HSBC, from offering RALs in the coming tax season. And of course, as we enter the final lap of the year, the usual tax loss selling and window dressing is occurring, which is further aggravated by the fact that nearly everyone who has bought HRB stock in the last 5 years is probably sitting on a loss.
What is the sustainable earnings of HRB? In the last fiscal year, which covers the 2010 tax season, HRB had a net income of around $480M. This is slightly down from the previous year, as a result of unemployment and a decline in the total number of tax returns filed. It should be noted that this is the lowest level of earnings in the past 10 years, barring 2007-2008 which saw huge write-downs due to HRB’s exit from the mortgage business. Depreciation runs about $20-30M higher than actual capex, so I estimate that HRB has a sustainable FCF of $500M. In the last fiscal year, earnings from RALs totaled $90M on pretax basis, and about $55M on a post-tax basis. About 16.8% of clients availed themselves of the RAL products. In the short-term, a portion of those clients may migrate to Jackson Hewitt due to the availability of the product, while some of those clients may be persuaded to accept their RALs in the form of the Emerald prepaid debit card, which is offered internally through HRB Bank. I believe that, eventually, an industry-wide consensus about the RAL product will emerge, and the RAL issue should not become a permanent source of competitive disadvantage. But to be conservative, let’s say that HRB loses 5% of its clients permanently, resulting in a $25M hit to cash flow. Therefore, cash flow is reduced by $80M, to $420M annually. Applying a conservative PE of 10 to this cash flow yields $4.2B in capitalization.
What about the balance sheet issues? HRB has $1.8B in cash, and $1.4B in equity. Stripping out the goodwill and intangibles from equity gives a net tangible equity of $190M. The $188M loss reserve for mortgage repurchases has already been accounted for under current liabilities. Management is confident that this amount is more than adequate, and I’ll take their word for it. Of the $595M in mortgage portfolio also on the balance sheet, 64% are subprime loans. Assuming a 70% loss to the mortgage portfolio (an extreme scenario that includes a total loss of subprime mortgages) gives a $416M reduction to equity, bringing it to around -$225M. Therefore, we can reduce the $4.2B in capitalization by $0.2B to account for balance sheet issues, for a final capitalization of $4B, or $13.11 per share. And let’s be clear, the above valuation implies that HRB stays permanently at its trough earning power in 2010, uses a historically low PE multiple for a blue chip stock, and also incorporates a draconian hit to its mortgage portfolio. In fact, I anticipate that a small increase in earnings due to cyclical recovery of the economy followed by a modest multiple expansion should boost stock price into the low $20s.
What is the long-term operating strategy of HRB? Under the stewardship of board chairman Breeden, the company has sold and discontinued its mortgage business, and refocused on its core tax franchise. Back in 2008, HRB has acquired the offices of its last large franchisee, and most tax offices are now company-owned, which allows better quality control. This contrasts with its main brick and mortar competitor Jackson Hewitt, which saw its reputation hit by fraud at several of its large franchisees several years ago, which was then followed up by a 50% loss of its RAL business in the last tax year due to the withdrawal of a major bank partner. As a result, JTX is now teetering close to bankruptcy, and there is a chance that H&R Block can gain market share as a result of continuing operational difficulties at JTX. HRB also faces strong competition from tax software company Intuit, which has 80% of the online filing market, with the remaining 20% share belonging to HRB. To further expand its online filing products and capture market share from Intuit, HRB has purchased the TaxACT software company in October 2010, and installed its competent management as head of digital products division. Furthermore, the board has announced a share repurchase program with about $1.5B left in allocation till 2012. This is an astounding 42% of the current $3.6B market cap of HRB.
In summary, I believe that current HRB management is making the correct decisions, and a weak brick-and-mortar competitor, renewed digital initiatives, and a recovering economy should significantly boost HRB’s stock price. Even in a double dip recession scenario, the company is protected to a large extent from the fact that tax preparation is an essential service for a large segment of the population.
Disclosure : I have a position in HRB.
{ 5 comments… read them below or add one }
Nice article. I’ve also been looking at JTX before summer 2010, decided not to buy but to keep looking at HRB. I will be buying HRB for a while I suppose, if the price doesn’t make some wild swings (in ether way).
Keep up the good work.
Loan participation fee income with HSBC was 146 million by itself, which is no longer will be available. You took a 5% loss of clients from the net. That is an erroneous assumption, in that a loss of these returns can not be assumed to be marginally the same as all other income. Block’s costs in this tax arena are mostly fixed costs. A tax preparer may be able to do two tax returns an hour which average their $200 a return fee. The preparer costs would only be about, on an average, $10 to $12 and hour. Those would be the marginal costs to apply against the income. Therefore, a loss of one return in this 5% section would be, at least, an average of $190 a return. Applying the 5% against the number of returns would be a loss of about 720,000 returns. That 720,000 should be multiplied by the $190 loss from each return, which would yield a reduction in income of nearly another 135 million. Adding both sections together would show a reduction in net income of about 270 million, or more than a 50% reduction in net income.
However, keep in mind that Block has been experiencing more that a 5% reduction in the number of returns each year. In the past, they have been able to match that loss with an increase in the fee charged per return. The average fees have gone from about $110 in 2001 to right at $200 per return in 2010. When the RALs go away, which they are, customers are going for the lower prices, rather than the quick return. I think they will prevail, but they will have to drastically restructure their business plan, go after different customers, and, in general, take a hicky for awhile.
Guy nailed it.
To Guy Minton. Your critique is absolutely correct in the short term. Assuming fixed costs, a 5% reduction in client count will have a much larger effect on profit margin and net earnings. But in the long term, fixed costs will scale with the number of clients. Management will not simply leave the current cost structure intact when faced with a declining client count. My 5% reduction to earnings is an approximation of the effect to HRB’s business, assuming scaling of fixed costs and client reduction. But in the short term, you’re right. The last minute change in RAL status leaves them little room to react, and earnings in 2011 will probably be even lower than 2010. However, as you have pointed out, HRB has enormous pricing power in this space. Not many companies can lift their profit from $100 per client to $200 per client . Only dominant companies in non-discretionary industries like health care and taxes can pull a stunt like that. In the long term, either every tax prep company will be allowed to issue RALs, or every company will be banned from RALs. Managements in the various tax prep companies will then react to any reduction/increase to client count by changing the cost structure. At the end of this realignment, I predict that HRB will GAIN market share from JTX due to the structural problems at that company (which cannot be solved by a one-time earnings bump due to the RAL gain in 2011). But… if your investment horizon is below 1 year, then yes, HRB is going to look pretty ugly in 2011.
The main contention that I have is that I really do not believe that, sans the RAL, that the pricing on the early filer is as elastic as you indicate. If anything, HRB will have to become more competitive in pricing to the independents. I do not think it will have to be any drastic change, but I definitely can not see the same increases in the future, as there have been in the past for the early filer (who now constitutes approximately one-half of the gross income from the retail offices).
However, I do agree with you that HRB has a large potential for gaining market share if they don’t go wild on raising prices to match temporary market share losses. This gain can result from the new preparer regulations. We may not see the main result of that until the end of 2013, however some attrition of competitors should be expected by the end of this year, and next year. Biting the bullet this year, and adding to their targeted market would be adventageous. They will pick the early filer back up in future years if they do not kill the golden goose with the bait and switch tactics currently being used in their advertisements. That is too much like the other competitors which will not survive, anyway, as you stated. The same structural problems in management exist in HRB as it does in the competitors. HRB was the initial model. I see them eventually overcoming some of this problem, but only after a lot of pain, and panic by shareholders.
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