Here's the long case for HRB. I did this write-up several weeks ago and if anyone takes the time to read it, I would welcome any questions and criticisms. I do own shares of HRB and I plan on holding for the next 3-5 years or until it becomes fully valued.
OVERVIEW
H&R Block ([t]HRB[/t] (<span style='font-size:11px'>LAST</span>: 17.78<span style='font-size:11px'> 3/29/2010 4:39:56 PM</span>) ) is the leader in tax preparation with about 16% market share, offering store-based and digital tax solutions. Throughout its history HRB has been a great generator of cash with high gross margins and operating margins in the lower-20% range.
However, for the past decade, the stock of HRB has gone nowhere thanks to previous management who thought it was a great idea to invest company earnings in things like a sub-prime mortgage origination business and a low-end retail stock brokerage business. Needless to say, these investments worked out terribly for HRB and shareholders paid the price.
But things have changed. HRB has become more focused and is poised to grow both revenues and profits from current levels and with potentially greater margins. When you understand the changes that have been ongoing at HRB for the past year or two, I think you will come to the same conclusion as I that HRB is severely undervalued.
THE CHANGES
Sometime between 6/30/2007 and 9/30/2007, activist investor Richard Breeden of Breeden Capital Management made his initial investment in HRB at a price range of about 16.50 and 18.50. HRB made up about 16.5% of Breeden’s portfolio at the time. Currently, Breeden’s stake in HRB has doubled and is currently the largest position in his portfolio at 27.3%. Breeden was SEC Chairman during the presidency of Bush Sr. and has a good reputation.
When Breeden got involved with HRB, he did a number of things to make the company more shareholder friendly. First he separated the CEO position from the Chairman position and got himself elected Chairman. Second, he eliminated the “staggered” board structure where directors were elected to terms of three years. As Breeden wrote in the 2008 annual report, “Staggered boards are one of several devices that typically result in more entrenched boards and management. By guaranteeing directors continuation in office irrespective of how badly a company is doing, staggered boards weaken accountability of directors to the shareowners whose interests they represent.” With every member of the board standing for election for one-year terms, they will be more accountable to shareholders.
Third, the Board allowed HRB’s “shareholder rights plan,” or poison pill, to expire. Fourth, a term limit of twelve years for directors was established.
Operational changes
In terms of operational changes, HRB sold off its sub-prime origination and brokerage businesses, reduced debt, resumed repurchasing shares, and have simplified their business in order to refocus their efforts on making the tax preparation business the best it can be. Right now, HRB has a Tax Services segment, which encompasses retail, online and software. HRB also has a Business Services segment, which offers accounting, tax and consulting services to middle-market companies via RSM McGladrey. And finally there is the Corporate segment.
It is important to note that HRB’s bank operations, which were previously reported as the Consumer Financial Services segment, have been recently reclassified, with banking activities that support the retail tax network included in the Tax Services segment, and the net interest margin and gains and losses relating to their portfolio of mortgage loans held for investment and related assets included in the Corporate segment.
ROOM FOR IMPROVEMENT
HRB has a lot of room for improvement in their tax preparation services. Over the past decade, previous management did a lot of foolish things in the name of improving efficiency. For example, they got rid of receptionists and free coffee. With fewer people to greet walk-ins, make them feel comfortable, and assure them that they will be able to see a tax professional, an estimated 3 million people simply walked in and then right back out. Also, management made efforts to consolidate their tax professionals by moving from many smaller buildings into fewer larger buildings. What happened here is that other tax preparers like Jackson Hewitt or Liberty simply took over the vacated H&R Block space and customers returning to that location the next year simply used whoever took over that space. I have also been told that under previous management, customers were often told that they could not use the same tax professional they used the prior year if that professional was busy with someone else! Now how insane is that for a company to tell a customer they can’t work with the professional they want to work with?
With everything that previous management had done wrong, there are 2 million who check in at the front desk but don’t begin the tax preparation process and there are another 1 million who begin the process but do not finish. There is enormous potential for HRB if they can turn into paying customers any percentage of those 3 million missed opportunities. This is all without mentioning the 4 million taxpayers who use HRB in a given year who do not return the following year.
HRB has reversed course on most if not of all these prior mistakes. Receptionists and free coffee are back. HRB is beginning to remodel their locations in order to make the customers feel more welcome. HRB has also started to funnel customers to their best tax preparers. In the past there was no rhyme or reason as to which available tax preparer got the next client, so under this new system of giving customers to tax preparers according to ability level it is far more likely to improve efficiency, improve the customer experience, and will also spur the other tax preparers to become better at their jobs so they can get more customers.
THE RIGHT CEO
The right person to lead the company from an operating standpoint is Russ Smyth. Prior to his current role as President and CEO of HRB, Smyth was President of McDonald’s Europe from January 2003 to January 2005. McDonald’s is the type of company that requires an intense focus on operational efficiency and the operations of HRB is exactly what needs to be fixed. Though the two companies are in different industries, they do have a similar type of temporary/seasonal employees that must provide the customer with a good experience. Smyth has become quite knowledgeable of the tax preparation business in the short time he has been at the company. He is strictly focused on operations and is aware of the myriad details which should lead to much improved efficiencies and cost controls.
MAIN COMPETITOR IN DISARRAY
Jackson Hewitt (JTX) is the second-largest tax preparer in the United States behind HRB and has lost significant market share over the last few years. The most recent problem for JTX (aside from an increase in unemployment) is the fact that they were only able to obtain half of the required funding they needed in order to provide refund anticipation loans (RALs) to their customers. As a result, JTX has lost many customers, customers who may be migrating to HRB. Also, as of March 17, 2010, JTX has said in a regulatory filing that it is likely to breach the financial covenants in its credit facility as of April 30, 2010. With its largest competitor in such disarray, HRB ought to be able to take advantage of this situation to its benefit.
WHAT COULD GO WRONG?
• Inadequate loss-reserving for their mortgage loans held for investment
o I don’t think this is likely given Breeden’s reputation and background as former SEC Chairman. I do not think Breeden will want to become known as the person who failed to get HRB to reserve adequately for possible losses on the mortgage loans held for investment.
• Government decides to greatly simplify filling tax returns, reversing a centuries-long course of increasing complexity
o Would the government really simplify tax filings to the point that people would no longer need HRB? I think not.
• Breeden could start meddling with and micro-managing the company
o A recent WSJ article described Breeden as taskmaster with an oversized ego. His meddling in the operations at Zales (another investment of his) made an already difficult situation even worse for that company. If it becomes clear that Breeden really is attempting to insert himself into operations of the company, this would not be a good sign for investors.
• Trend towards using online or software to file taxes accelerates
o There is a real trend here, largely due to the record numbers of unemployed who are just trying to save money by doing their own taxes. However, most people, if they have the money, prefer to have a human being help them with their taxes. People naturally want to explain their specific tax situation to someone and want reassurance. People also like to offload responsibility on to others and HRB stands behind their filings with a guarantee – if they make a mistake, they will pay any additional interest and penalties. I believe that when employment increases, more individuals will go back to using a tax professional.
VALUATION
Using a DCF analysis, I value HRB at about $28-29. With evidence of improved revenues and margins, the intrinsic value of HRB could move up to the lower-to-mid-$30 range. Also, there is one consideration that could prove to greatly increase the share price of HRB and this is the possibility that Breeden and Smyth are turning around HRB with the ultimate goal of selling to private equity. Breeden’s actions of removing the poison pill and eliminating the staggered board structure will definitely make the company easier to sell to the highest bidder. If that day ever comes, HRB would fetch a price substantially higher than its current price of $16.80. |
