H&R Block Bear's Den
by Bill Barker ([email protected])

Even allowing that H&R Block is the first name, or at least the first two initials, in tax preparation, I find it a bit difficult to justify purchasing a company at a current P/E multiple of about 37 that only has a median five-year estimated earnings growth rate of 15% -- and a trailing five-year earnings growth(?) rate of -5%. Yikes!

Okay, okay, I know what you’re thinking. Because of Block's recent sale of its stake in CompuServe, it makes more sense to back out that cash and measure by enterprise value. I won’t dwell on the fact that the company sold the 30 million shares of WorldCom it received for its stake in CompuServe less than two months ago when WorldCom was $9 a share cheaper, meaning that Block missed out, after taxes, on about one-and-a-half years’ worth of earnings. D’oh! Guess I just did. On an enterprise value/earnings basis, Block is now trading at about 28x the end of fiscal year earnings, i.e. “only” about double its growth rate.

That type of lofty valuation for a mature company growing earnings in the mid to high teens is usually reserved for the type of consumer giant owned by Warren Buffett, but I don't see where the historical performance of this company, or its market position, makes it comparable to a Gillette or a Coke. Actually there is one Berkshire Hathaway holding that Block does remind me of a little. Like McDonald's, Block dates its growth back to the Fifties, is mainly a franchise operation, is the number one player in its sector, and has basically saturated the domestic market. But the thing that really reminds me of the Golden Arches is the "Do you want some fries with that?" type of costly and unneeded extras that the firm now attempts to push on every customer who has already placed a final order for what she actually wants. (That's partly unfair -- there's nothing unneeded in my mind about McDonald's fries.)

One example of the type of financial “extra” being pushed (and that Block's earnings growth is now dependent on) is the Refund Anticipation Loan (RAL). By filing electronically, any taxpayer can now receive by direct deposit a return from the IRS in approximately two weeks. But, "When Fast Just Isn't Fast Enough!" as the breathless enticement on my local H&R Block office window proclaims, for a mere finance charge of $40-$90 (plus, in some areas, additional paperwork charges and, of course, the charge for providing the electronic filing), through a partner bank Block will loan its customers in about five days what they would receive anyway, for free, in fourteen days.

So the company is providing a loan with an 80% to 312% annual rate (before accounting for the processing and service fees). The fine print declares, "Because the ANNUAL PERCENTAGE RATE on a RAL may be high in certain cases relative to other sources of credit, you may wish to use such sources; e.g., credit cards... instead of a RAL." Indeed you may. At those rates, I suspect that La Cosa Nostra offers loans on extremely competitive terms. As a large number of the users of this service are squandering a significant percentage of their earned income tax credit, with time the outrageously usurious effect of this part of Block's business may come under the scrutiny of our elected officials. Or 60 Minutes. Or at least some Fools.

The consumers, though, are already exacting their revenge on the company’s bottom line through another of Block's financial services. Yes, the company is actually managing to lose money on its credit card division “due to a deterioration in the quality of the credit card portfolio,” according to the third quarter 10-Q filing. That deterioration seems to be coming during a pretty good economic time. One wonders what will happen when the economy is not quite so robust.

Not satisfied with just losing money on credit cards, in December of last year Block acquired Option One, a sub-prime mortgage lender. Mortgage service now accounts for 10% of total profits. In light of the uncertainty and rather extreme potential downside associated with such specialty financial services, an investor in Block should be aware of just what he or she may be getting into. Being able to decipher the financials of sub-prime lenders, with their gain on sales accounting and other vagaries, is a challenge even for those who actually make a living at analyzing the companies on a full-time basis. The full picture of Block's mortgage business operations is not decipherable in any detail from Block's public filings from what I can tell, so an investor is left to make a judgment based upon history -- and the history (e.g. CompuServe) is that this company has not succeeded outside of the tax preparation business.

I could make arguments about the increased competition from rival Jackson Hewitt and/or tax preparation software, or the decimation that some potential future flat tax would wreak upon the stock, but why bother? I consider those disingenuous arguments -- Block has a profitable tax preparation business that is not likely to go away any time soon. But that’s really all that it has, and it just isn’t worth anything close to today’s price given its history of failing to grow through any of its previous attempts to branch out into other businesses.

Next: The Bull Responds