H&R Block: Welcome to the Sausage Factory, All You Value Investors
It’s easy to envy momentum investors. According to the stereotype, Mr. Momentum spots a blip racing upward across his screen – it could be migrating geese for all Mr. Mo cares – and buys some shares. He then hangs on until the shares start to fall, cashing out and having spent little or no time working to understand the underlying business. Adios, stranger! Ignorance is bliss.
Value investors, on the other hand – delve deeply into a company’s financials, scouring the 10-K, worrying over Internet scuttlebutt, reading up on the competition, charting the fundamentals (not just the stock price). In the process, Ms. Value often has the shit scared out of her, so ugly are the doings at many publicly-traded companies. Think of cigarette makers, surely a value play. Their product literally kills people and the litigation disclosures alone are enough to make even the hardiest bottom feeder lose her lunch.
But the crucial question when one tours the sausage factory of disclosure is this: does all this scary stuff make it a crummy company; or, is the underlying business in fact a fabulous thing, since it continues to churn out earnings even as disturbing events occur? If it’s the latter, then strong stomachs can lead to profitable investments.
All value stocks aren’t frightening, but being beaten up is often what makes for a bargain. Which brings us to H&R Block (HRB), which is either a great momentum play — for short sellers – or a beaten-to-a-pulp mess deserving of a look by value buyers. YCharts Pro Ratings suggest it’s the latter. Let’s have a look at the stock chart.
There was indeed a sickening slide over the past year, as the famous preparer of tax returns prepared fewer said returns, continued to take its lumps from a mortgage business it exited with tail between legs, and kept plenty of lawyers busy defending lawsuits over various business practices some have called unsavory. Oh, and a CEO brought in to turn the mess around in 2007 decided he’d had enough and split. Sausage, indeed.
But you know what? Even with all those ills, H&R Block posted net income for the year ended April 30 of $479.2 million.
That gives H&R Block a p/e ratio of about 9. And an earnings yield – a nice way of comparing a stock to a bond yield – of more than 10%.
A nice bit of the earnings are paid out in dividends.
So, H&R Block is cheap, if it can continue to churn out half a billion dollars a year in profit. Can it?
Broadly, it would seem management has done its best over the years to break the business, and, thankfully, they failed. It ain’t growing. And it ain’t pretty. But it must be indestructible, the permanent payroll of 7,700 people reliably ballooning to 110,000 to staff more than 11,000 tax prep offices in the weeks leading up to April 15.
There are risks. Of the nearly $3 billion in revenue derived from tax services in fiscal 2010, about $400 million came from the business of making loans to people in anticipation of their tax returns, or in fees for guaranteeing filers that, should the IRS ask for more in taxes, H&R Block will cover certain amounts. The loans are high-interest rate, one variety of them yielding an unseemly 35.21%. And the guarantees, marketed as “Peace of Mind,” are probably a lot better deal for H&R Block than for the filers. All told, the loan and guarantee operations have attracted a nasty bunch of lawsuits. The loan business suffers further because the IRS has become a more prompt payer; and some banks have decided they don’t like the loan business.
Block also loses market share to Intuit (INTU) and its TurboTax software. And the Block tax client demographic isn’t so upscale: the company’s “key client segments” suffered unemployment rates during 2009’s fourth quarter of between 15% and 30%, “far in excess of national unemployment levels,” Block says.
Debt is a bit high, and liquidity a tad low, as measured by a current ratio below 1.
The company spends about $250 million a year on advertising, and one wonders whether it couldn’t a.) generate more traffic from its ad budget and b.) spend more to regain lost market share. And costs seem an area to explore further. Closing 400 poorly-performing offices and axing 400 jobs, announced last May, was part of a plan to save $140 million or so by fiscal 2012. Is there more low-hanging fruit?
Richard Breeden, the former Securities and Exchange Commission chairman-turned-activist investor, is Block’s chairman. He waged a proxy fight for board seats in 2007, ousted a CEO, and tried to hurry Block out of the looming disaster in mortgage lending, which it had wandered into. Breeden’s a smart guy, and his reputation is on the line at Block. The shares were at about $19 when he arrived. They’re around $13 now.
So, there you have it. Durable franchise. Beaten-up stock. Scary business problems. That’s often value investing.
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