H&R Block Financial Analysis December 2016

Taylor 1



Shawn Taylor
Dr. Robert Perkins
MBA 524-85 Financial Decision Making
23 December 2016
H&R Block
OVERVIEW
H&R Block (NYSE: HRB) is a publicly traded corporation operating in the tax preparation industry (NAICS Code 541213 / SIC Code 7291 - Tax Preparation Services). HRB provides tax preparation to taxpayers at over 12,000 locations in the United States and abroad. In fiscal year 2015, ending after the 2016 tax season, HRB had revenues of $3.1 billion and prepared 24.2 million tax returns worldwide (Mission).
OPERATIONS
H&R Block "looks at their clients lives through tax and looks for ways to help." They enable Americans to file tax returns to the IRS to "get their billion back." Henry and Richard Bloch [sic] opened the first professional tax preparation office in 1955. H&R Block provides tax preparation services at their many offices (most Americans have an H&R Block office within five miles of their house), through their line of personal tax software, and at their new line of Block Advisors offices. Block Advisors is a new branch of HRB in its first year of operations since February of 2016 (From Main Street to Wall Street). The more than 280 Block Advisors offices nationwide specialize in year-round personalized tax preparation and tax planning for individuals with more complex tax situations. Block Advisors provides small business owners a one-stop shop for all their accounting, bookkeeping and tax needs. Most of the agents in Block Advisors offices are Enrolled Agents of the IRS or Certified Public Accountants. H&R Block also offers franchising for businesses who wish to buy into a franchise or sell their existing tax service. HRB is a multinational company, with branches in North America, Brazil, Australia, and India, however the vast majority of its operations are in America. It has offices in all U.S. possessions and territories, and it has offices on many military bases around the world.
PRODUCT OFFERINGS
Over the last two decades, Block took on projects like tax software (TaxCut), investing (H&R Block Financial Advisors), mortgage banking (Option One Mortgage), and banking (Bank of the Internet). Block's current major investment project is its new brand Block Advisors, which addresses small business accounting needs. To augment this business, Block partnered with cloud accounting software firm Xero for its internet business accounting software and Funding Circle for small business loans. On the tax preparation side, Block added certain new additional products to augment its tax preparation suite such as same-day Refund Transfers to compete with other brands, a $1,000 line of credit (Emerald Advance), an identity theft protection package (Identity Shield), an audit protection package (Peace of Mind), and prepaid debit cards as an alternative to checking (Emerald Card).
COMPETITION
Block's competitive landscape includes direct competition from other tax prep agencies such as Jackson-Hewitt and Liberty Tax. Indirect competition comes from local CPA and legal firms as well as from other companies offering tax software. Opportunities for Block include expansion into the auditing and assurance industry, possibly eventually competing with Big 4 accounting firms such as Deloitte or KPMG. Another opportunity may be the investment banking industry, competing with firms such as Morgan Stanley. However, Block has expressed their unwillingness to enter this now highly regulated industry. Threats include new entrants into the tax preparation market, a market attractive due to guaranteed customer base but unattractive due to the low revenue and seasonal nature of tax preparation.
STRATEGY
H&R Block's major strategic plan is to capture a larger part of the assisted tax preparation market share currently held by CPA's and Independents (30% and 48% respectively, according to Gale Business Insights). Block faced stiff competition from software and other tax preparation firms, and its EPS fell from $1.71 in 2015 to $1.49 in 2016 (Mergent). The goal of its new subsidiary brand Block Advisors is to take some of the market share from CPA firms. I think Block should continue down this track with a chain of CPA firms developing under the Block name. Not only is the tax preparation market dwindling, the small to medium sized business market is relatively untapped, and these types of clients bring a significantly larger amount of income and have much higher loyalty. This increases earnings potential and solves the problem of lost market share in the tax preparation industry. This may increase the prestige of the Block brand. It may be a very efficient use of office space that is normally left empty during the off-season. It also will help Block bridge the gap to being a large-company accounting firm if that is a direction they desire to pursue in the future.
POLITICS
There are many political influences on Block's business landscape that have caused it to restructure. The Dodd-Frank regulations forced Block to sell its BofI bank, mostly due to reserve restrictions that did not align with Block's lean and mean capital structure. It appears to me that Block was preparing for a Democratic president with its low-flying stock price and its increased debt on the balance sheet. Trump could be a bad thing for the tax preparation industry. He has stated that he wants to simplify the tax system and "put H&R Block out of business" (Palmer). In April 2016 Elizabeth Warren (D-MA) introduced a bill in Congress to have the IRS auto-file returns for Americans with simple tax situations such as one W-2 and a 1040EZ and offer free online filing for others. If Block wants to truly re-energize its stock, though, it is going to have to reconnect with its individual tax customers through sales, service, and community involvement.
SOCIAL RESPONSIBILITY
H&R Block has initiatives to give back to communities. Their flagship endeavor is their Dollars and Sense program, which is a national program to teach financial literacy in schools. It is a course curriculum that teaches students the basics of personal finance. All of this is provided free, and Block even extends scholarships through the program. Block has also partnered with the United Way to provide free tax preparation through its MyFreeTaxes program. The H&R Block Foundation is a philanthropic organization through which Block contributes about $2.5 million annually to various causes (Community Involvement).
FINANCING
H&R Block has market capitalization of $5,001,903,418 with 219,093,448 shares outstanding at $22.83 per share. Block has had a very bad year. They were one of the worst performers on Wall Street for most of the year. Their stock price has dropped 36% over the year, making this year their worst since 2010, when their stock dropped 47% (Caruso). Tax office traffic has long since slumped since the advent of home tax software, and Block had to sell its bank division in 2013 due to increasing Dodd-Frank regulation of the banking industry. According to Block CFO Greg Macfarlane, the "additional requirements for reserve capital did not align with Block's capital-light business model" (Fed Headache). However, in the light of this year's financial troubles, Macfarlane was demoted to an operational role. They invested heavily in long-term debt, increasing long-term debt holdings by 300%, while at the same time reducing liquid assets by 400%. Block has undergone heavy cost-cutting this year and has laid off 250 salaried employees. If the market remains stable, Block will have a streamlined and efficient capital structure. However, if the market tanks, it will be in serious financial straits, stuck with huge amounts of debt and no cash. Block is all in.
INVESTOR RELATIONS
H&R Block's Fiscal Year 2016 Annual Report can be found on its website in the press release dated June 17, 2016 under Investor Relations. A summarized version can be found in the Hoovers company database. They were audited by Deloitte, who gave them an unqualified opinion, i.e. they did not find anything to suggest that the statements were inaccurate or incomplete. Block's fiscal year ends in April, right after tax season. Some accounting firms do this because tax season is the busiest time of the year, and summer is often the slowest, and therefore the best time to compile financial statements.
HRB has had anything but an average year. Dodd-Frank capital and reserve requirements hit H&R Block Bank hard because the consolidated corporation desires to be capital light due to its seasonal nature, so they sold the bank in August of 2015. This transaction cost HRB $419M because of net liabilities the bank owed. Although Block's specialty is assisted tax preparation, it is usually dabbling in related financial businesses. Over the years, this included computing, tax software, investment banking, and mortgage banking. In March of 2016, Block opened its first Block Advisors office. Over the past year, Block saw its stock plummet from $36 to $22. In his letter to shareholders, CEO Bill Cobb acknowledged this setback and attributed it to a decline in customer volume in both the assisted and software segments. The board of directors also approved a $3.5 billion share repurchase program and repurchased 56.4 million shares, representing 20% of outstanding Block shares. They issued $1 billion in long-term debt and opened a $2 billion line of credit. They increased the quarterly dividend by 10% to make up for previous lean years.
RATIO ANALYSIS
Figure 1 shows certain standard financial analysis ratios for H&R Block calculated directly from their 10-K SEC filings. The ratios are color coded from green being safe to red being risky. The company has very tight current and acid-test ratios, but this is due to the seasonal nature of the company and their desire to be very capital light. Profit margin and return on assets are very strong, and the company is increasing dividends. Most sales are cash sales. HRB took on a very large amount of debt this year. They have a dangerously high amount of debt—their debt is equal to their assets. Again, most of their offices are leased and they are capital light, coupled with the fact that this is an exceptional year of debt and not indicative of typical operations. Return on equity, price to earnings ratios, and economic value added are all positive.



Figure 1
Financial Analysis

LEVERAGING VALUE
In my opinion, Cobb made a smart move and took advantage of the downturn in the stock value. He initiated a repurchase plan to take advantage of the low-value stock, both buying the stock at rock-bottom prices and reinvigorating stock trading. He also took advantage of time value of money concepts. With the possibility of interest rates rising, he made the decision to onload debt at a better rate than he may have gotten in the future. Interestingly, now that there is an unexpected Republican president who purports that he will encourage business by lowering taxes and interest rates, it will remain to be seen if this was indeed wise. However, as of December 14th, the Federal Reserve has begun the process of raising interest rates by 2% (Appelbaum). Also, debt is much cheaper than equity capital. This debt onload makes Block more leveraged. This can be a disadvantage in a down economy, especially if you don't have the liquid capital to cover a hefty pile of long-term debt. However, it is very advantageous if the economy is on the uptick and you can invest your money in projects with a better return. Block took on risk by financially leveraging the company (Keown, Martin and Petty 482-492). It has took on a large amount of debt despite its seasonal declining income, although it is notable that Block made a shift to a more year-round model with Block Advisors. This is balanced by the operational leverage it has gained by offloading H&R Block bank and keeping its capital light business model.
RISK AND RETURN
H&R Block (NYSE: HRB) is a low-risk stock rated hold by most analysts (New Constructs; Reuters; ValuEngine). HRB has a beta of 0.53 (ValuEngine). This means that HRB's returns are usually about half that of the market's returns, and it also means that there is typically less risk. The average beta for non-bank financial institutions is 0.65 (Cost of Capital). Keown, Martin, and Petty define risk as the potential volatility of returns on stock (187). This year's return on HRB stock has shown a very atypical amount of volatility. ValuEngine rated Block's volatility at 27.44% compared to financial sector volatility of 49.48% and S&P 500 volatility at 19.24%. However, when compared to the S&P 500, Block shows very similar patterns (S&P 500). According to ValuEngine, H&R Block is ranked in the 59th percentile for volatility (i.e. 41% of stocks are more volatile). Block has a Sharpe ratio of 0.30, which is relatively low, meaning that it has low momentum and does not yield a high return for a proportionately high amount of risk. This is not bad; it just means that the stock is a more stable stock perhaps best suited to hedge against more risky investments.
CAPITAL BUDGETING
Block stock has dropped 39.6% this year (ValuEngine). H&R Block CEO Bill Cobb attributed this drop to customer attrition. He took several steps to ensure a robust recovery, including selling off Block's bank subsidiary, investing in more advanced accounting services under the Block Advisors brand, and investing in the community with programs such as its educational program Dollars and Sense and its freshly released free-file for 1040EZ and 1040A filers through February. In this way, he plans to better serve current clients and reach out to new ones. Over ten years ago, Block indicated its intent to move away from traditional budgeting—transposing one year's budget to the next—to a more modern project-based capital budgeting structure (Leahy). Cobb's capital budgeting plan included several key moves. Due to increased regulation and impending compliance costs, Block divested their bank subsidiary. They continue to use BofI for such things as the management of their Emerald Card program, but they do not own it. H&R Block currently holds 17% of the market share of the tax preparation industry (Assisted Tax Preparation Industry). Realizing increased competition from other tax prep services and software, Block invested in different markets with Block Advisors, catering to higher end clients with complicated returns, small businesses, and financial planning. By doing this, they hope to substantially increase returns. The tax prep industry typically had low returns per client, so Cobb plans to increase rapport with the current market by offering more free filing and community services. He took advantage of low stock prices and low interest rates. He repurchased approximately 7.6 million shares for an aggregate purchase price of $168 million during the second quarter, bringing total share repurchases for fiscal 2017 to 9.6 million shares for the year (H&R Block). Block borrowed heavily to cover weak returns this year and the Block Advisor rollout. Cobb is focusing on earnings per share (EPS), which have risen 3.14% in the past year and are planned to rise from $1.59 this year to $1.89 in 2019, despite the fact that HRB stock has tumbled 39.6% in the last year (Mergent). Block has a weighted average cost of capital (WACC) of 5.6% and a return on invested capital (ROIC) of 18.8%, resulting in an economic earnings margin of 13.2%, which are slightly better than the industry average (New Constructs).
CAPITAL STRUCTURE
Block's cash on its balance sheet was down 55% from $2 billion in 2015 to $896 million in 2016. According to a SWOT analysis by Global Data, this cash position is Block's greatest weakness. The nature of Block as a seasonal business with a capital light structure highlights this. Over the last few years, there were arguments that Block was keeping its stock investment grade to keep costs of capital down and to maintain access to commercial paper markets. However, after selling off its bank and investing in its new small business chain, it opted to use a line of credit for its short-term cash needs. In 2015 Block opened a $2 billion Committed Line of Credit to improve its financial flexibility. The stability and low beta of the financial sector make it a good candidate for debt financing. Despite Block stock's performance, its company revenues remained steady. Using a risk-free rate of 3% on a 10-year U.S. Treasury Bill, a 50-year average stock market risk premium of 7%, and a beta of 0.53, HRB's cost of equity capital is 6.7% using the capital asset pricing model. According to New Constructs, Block's weighted average economic cost of capital is 4.7%. According to Mergent, Block's return on equity is 40.22%, which is well above its cost of capital. All in all, this means Block is a very safe company to invest in, but it will yield less than the market on average. However, this is typical of the banking and finance industry.
DISCUSSION AND CONCLUSIONS
H&R Block is a stalwart tax preparation company with a very solid reputation for quality. Many tax preparers consider them somewhat high-end. However, since the recession, they have had a hard time getting back on top financially. Earnings per share momentum is negative and dropping, from -0.35 last year to -0.55 this year (H&R Block). They dropped their banking branch, added the Block Advisors branch, re-energized its franchising operation, cut costs, and invested heavily in the future. While their performance this year has been abysmal, they increased long-term debt by 300%, signaling that they are confident in the future. So, the company may in fact be a gem in the rough. One may be tempted to perceive this correction as an opportunity to buy a high value stock at a rock-bottom price.
Block took advantage of the dip in the market to make some very advantageous capital purchases. Realizing that their traditional tax preparation market may be drying up to a degree, they used capital budgeting techniques to make some strategic maneuvers which will hopefully position them for increased success in the upcoming years. Analysts are divided on whether these were smart moves, and their stock price predictions vary widely from positive to negative (New Constructs; ValuEngine). The political landscape is changing quickly. By reducing equity, increasing debt, and going all-in, Block put some skin in the game and they are set to separate themselves from the tax prep pack and to bridge the gap to a full accounting firm. If you have Block stock, hold it. Otherwise, you should consider buying.




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