YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

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H&R Block’s stock (ticker: HRB) reached a 52-week intraday low of $12.51 last Thursday in anticipation for expected losses in their quarterly report. It appears that investors were fearing the worst about HRB’s ability to deal with its mortgage loan repurchase obligations and mortgage loan portfolio, regulatory changes that would affect its refund anticipation loans, and also changes in the tax preparation industry in general. How much should a potential investor worry about the company’s ability to produce future earnings?

While they appear scary on the surface, HRB’s mortgage obligations are not quite as bad as they initially appear. When you hear terms like “repurchase obligations” and “$33 billion mortgage portfolio,” it can incite fears. This is not, however, like all the credit-default swaps that brought down AIG. These are loans that are put back to HRB as a result of deceptive loan practices. Alan Bennett, now officially the new CEO, said yesterday during their first quarter earnings call, that while investors seem concerned about the obligations that “seems to be subject to some speculations that is not based on fact.” What are the facts? When the mortgage operations were sold off in April 2008, they established a loan repurchase reserve of $243 million. Since that time, they have received $686 million in claims which so far has resulted in $55 million in losses out of the $557 million claims they have finished reviewing, leaving the current repurchase reserve at $188 million. During the Q&A, Bennett mentioned about 2/3 of those losses occurred in the first half of that period. In other words, time is on their side. As time passes, the claims become fewer because the poor lending practices have already largely been exposed. Of course, if the housing market worsens, more claims could surface. But considering that the duration of the average home mortgage is 10 years, they have a very conservative cushion built-in. With about 320 million shares outstanding, even if losses exceed estimates, the impact to the valuation of the share price would be pennies.

What of their mortgage loan investment portfolio? We like to look at worst-case scenarios, and even then, HRB’s potential loss exposure is minor. The principal balance of mortgage loans stands at $563 million. Imagine a scenario worse than the worst-case scenario where every loan defaulted. If you assume the recapture rate is 50%, in this preposterous example losses would amount to $0.88/share. So, despite some small level of risk, HRB has mostly sold off their exposure to mortgage loans and reverted back to their more profitable business core of tax preparation.

Most important to an investor should be the future of HRB’s profitable core as a tax preparations business. In the current market conditions, DIY (do-it-yourself) firms such as Intuit Inc. have seen increases in their market share while HRB’s market share has been sliding. But is tax preparation going the way of newspaper companies, eroding slowly until only self-serve online tax preparation software is all that is left? It is certainly unlikely!

First, taxes are inevitable, and in our current environment it isn’t likely that the U.S. tax code is going to get any simpler. In fact, the pages of tax code have grown at an exponential rate – no joke! Second, we believe that while there is some movement from HRB customers towards self-service products, it is more likely that the decline in their tax preparations is largely for an entirely different reason. We like to believe TurboTax’s increase in market share is simply the transition of people who have previously prepared their taxes at home discovering the advantage of using online software. In other words, these so-called “potential clients” were never in HRB’s target market.

So, if we don’t believe HRB’s decline in tax preparations is largely as a result of clients transferring to online products, where are they going? According to the company itself, it projects that somewhere between 15-30% of its potential clients are unemployed in the current market (compared to the current 9.5% unemployment rate). If true, there would definitely be fewer people in need of HRB’s services – whether that be because they don’t need to file or simply can’t afford to pay taxes. With unemployment levels this high, and increasing amounts of people moving from doing their own taxes on paper to doing them online, its no wonder that it appears HRB’s market share has decreased!

There will always be a large group of individuals who would rather not deal with their taxes by themselves and prefer the peace of mind and human connection that HRB offers, and we like to believe that HRB’s brand name recognition has created a large enough moat to retain these clients.

To us, the major concern is what will become of their lucrative refund anticipation loans. The government has viewed the practice of issuing rapid refunds as predatory lending. In an attempt to curb the practice, the IRS decided to eliminate its “debt indicator” – data that shows outstanding taxes owed or judgments which would reduce tax refunds. As a result, underwriting becomes more difficult. Yet these loans are still going to be demanded. So, instead of reducing their underwriting participation, HRB will need to raise prices by refunding less, thus making them look even more predatory than before. Here we have yet another example of the government meddling in the economy and creating an unintended consequence. The battle is still raging, and thus our concern is that the government’s actions may reduce HRB’s revenues in one of their most profitable operations.

A note about management – HRB is infamously known as making some dumb strategic decisions such as getting into the mortgage business at the peak. We’re pleased to see them making choices that will change this poor reputation. For one, they have been focusing on running a more efficient, lean business by shedding underperforming offices and shrinking unnecessary staff. Another positive strategic move is they are continuing to convert more and more company owned offices into franchises, a much more profitable business model. We also applaud management for repurchasing a significant amount of shares when their stock is getting hammered. In the first quarter of their fiscal year, they spent nearly as much on stock repurchases as they did during all of last year – $235.7 million last quarter versus $250 million last year.

Most importantly, HRB is trading at less than 7 times cash flow. It hasn’t traded this low since…well…to our knowledge, ever! While HRB may be experiencing some struggles, it certainly doesn’t deserve to be priced like a train wreck waiting to happen.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | September 03, 2010 | Permalink

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