H&R Block Bull's Pen
by Louis Corrigan ([email protected])

You've paid The Man and finished cursing. Now you're ready to support the kind of tax reform that makes filling out a 1040 truly EZ.

Hello! Wake up! What the flat-taxers willfully ignore is that Americans believe in a progressive tax system. Complexity is fine if it serves our notion of fairness. Second, simplifying the tax code inevitably involves reducing taxes, so you'd have to decide which branch of the government to close down. Good luck! Finally, tax forms are complicated because Americans feel comfortable using the tax code to influence behavior. Don't believe me? Just try to get rid of the home mortgage interest deduction.

Bottom line: We're stuck with death and (complicated) taxes.

H&R Block has a dominant share of the tax business. The firm has 8,800 U.S. offices and over 10,000 worldwide, including offices in Canada, Australia, and the U.K. Over half are owned by the company, the rest franchised. In filing or preparing 13% of U.S. tax returns last year, Block served 15.6 million Americans (up 5.4% for FY97) and 18.2 million taxpayers worldwide (up 4.5%). It also has over 600 special offices serving 698,000 premium customers (up 8.6%) with more complicated returns. Jackson Hewitt, its closest competitor, prepared less than 1% of taxpayer filings last year from its then 1,400 locations. (It was acquired in January by Cendant <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CD)") else Response.Write("(NYSE: CD)") end if %> and now has over 2,000 stores.)

Block has tax preparation down to a near science. A customer brings in the tax info, and an hour later the return is done. Block can then file it electronically (it accounted for 51% of all electronic filings last year) and offer the customer a refund anticipation loan (RAL). Though the company has nearly 80,000 employees during the tax season, it requires just 2,000 full-time employees. Plus, it's got a viable contender to Intuit's <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTU)") else Response.Write("(Nasdaq: INTU)") end if %> TurboTax with its Kiplinger TaxCut tax preparation software, which claims maybe 25% of the market. It has also launched a tax payment website (www.taxcut.com).

Overall, Block's revenues have grown steadily from $766 million to $871 million to $1,097 million in the last three years. Income from continuing operations during this period has run from $98 million to $125 million to $144 million, with EPS growing from $0.92 to $1.18 to $1.36.

Yet while most large-cap companies have recently enjoyed good times, Block's stock has only now recovered to levels seen in the spring of 1995. The main reason is that the company basically mismanaged its sale of CompuServe, taking 20% of the trailblazing online service public in April 1996 but continuing to pour money into it even as America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %> was becoming online king. CompuServe has now been sold to AOL by way of WorldCom <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WCOM)") else Response.Write("(Nasdaq: WCOM)") end if %>, and Block recently cashed out its 30 million shares of WorldCom at $34 3/8 apiece.

With over $1.1 billion in cash and securities, Block has announced plans to buy back up to 15 million shares (14% of the total). It also plans to bring renewed focus to its tax business and to use its strong franchise to offer other financial services. Last year it acquired Option One Mortgage, which originated $507 million in loans during the latest quarter. Last year, Block started offering mortgages through 31 of its offices and 5,000 mortgage brokers nationwide. With unique access to millions of customers who already put considerable trust in the company, Block has substantial room to expand the mortgage program as well as greatly broaden its financial service offerings.

Plus, tax reform is always a boon to H&R Block. With changes this year in capital gains rates, more people than ever before have been seeking professional tax help, and Block has been able to charge more for services. Tax-preparation revenues jumped 17% in the first two months of this year.

So FY98 (which ends in April) should be strong. First Call estimates project earnings per share will vault 23% to $1.67 after growing 15% last year. EPS should leap another 27% next year to $2.12. An enterprise value-to-sales ratio of 3.3 is more than reasonable given net margins in the mid-teens. With a YPEG fair value of $53 based on the industry's 25% growth rate, H&R Block appears to offer a 13% upside over the next year. That's not bad, considering it has already doubled in the last 18 months.

But with one of the most recognized and best-positioned brands in all of the financial services industry, Block's franchise remains woefully underutilized. Think about it. The company has access to a captive base of 16 million U.S. customers at precisely the moment they're thinking most seriously about finances. Block could offer any number of additional services itself or market the services of strategic partners. Its current stance is a bit like America Online focusing on subscription fees without really bothering to cultivate advertising or merchandising revenues.

How underutilized is Block's core franchise? Financial services accounted for just 10% of the firm's revenues last year, with refund anticipation loans (RALs) amounting to just 5% of revenues. By contrast, Jackson Hewitt provided RALs and accelerated check requests (ACRs) to 54% of its customers, pushing its financial services stream to 30% of overall sales even without bothering with mortgages or credit cards like Block does. Because of cross-marketing opportunities, Cendant was willing to pay $480 million for Jackson Hewitt. That's $480 per customer or 13.8 times sales.

H&R Block certainly has a far more mature franchise, with less room for U.S. store expansion. Still, another firm's customer database would be useful to Block. Moreover, due to its more established relationships with customers, it ought to be an even more valuable property than Jackson Hewitt for a firm that could sell its financial services through Block stores. Based on Cendant's bid for Jackson Hewitt, Block might be valued at between $7.5 and $16.7 billion. With about 90 million shares outstanding after the buyback, that would be a stock price between $83 and $186.

That's enough to get one thinking about how valuable Block might be were it matched with the right partners or acquirer.

Next: The Bear Argument