H&R Block: No more pesky distractions – Focus on what matters (NYSE: HRB)

Street view of the H&R Block entrance – tax preparation company in Vancouver

Margarita-Young/iStock Editorial via Getty Images

H&R Block (HRB) is in the bucket of high-value stocks that the market thinks it can ignore until it’s gone. The valuation reflects more than that. To market credit, management has yet to give investors and analysts who cover H&R Block a reason to set a higher multiple. Profitability is no longer enough. Tobacco, oil, traditional automakers, banks have also been dragged into this over the years. Everyone is believed to have a The Achilles heel of their very long-term business. The market asks such companies to “prove it”. Simply put, prove your business isn’t headed for inevitable decline. The burden in this case lies with management.

Nowhere do I say that H&R Block’s going concern is in jeopardy or that H&R Block faces impending doom any time soon. I wouldn’t long the stock if it did. In this article, I’m just going to outline why I think the market has, and will continue to avoid, H&R Block.

Has H&R Block suffered a permanent impairment?

I happened to come across a Bloomberg Second Measure report that observed the impacts of COVID-19 on the tax market. This included market share and timing of tax reporting.

Looking at the chart below, it’s clear to see what happened during the pandemic.

Tax preparation market share

Market share

Second measurement

TurboTax’s (INTU) market share gain came directly at the expense of H&R Block. For obvious reasons, many customers have decided to file online with online support or DIY. The name highly associated with this practice is obviously TurboTax.

Has H&R Block been permanently weakened by the pandemic? I think it’s hard to say that’s not the case, unless a new report shows a change in trend. I see no reason why a client who successfully transitioned from in-person assisted tax preparation ($$$) to online help ($$) or DIY ($) with TurboTax, would ever come back.

The FY22 tax season will be H&R Block’s first normalized year since FY19. If all goes as planned, all 2022 returns will be included in the FY22 annual report. This will create an opportunity to make comparisons to FY19. I think it will be particularly important to examine three elements. Deposit volume, EBITDA margin and employee compensation expense.

Spruce – The product no one asked for

Wave has been referred to verbatim in regards to the catastrophe of acquisition and implementation. I started to feel like the negative impacts of public relations had passed on to us.

Leave it to management to spend a year of R&D creating a mobile banking platform in spades. Although as investors we knew it was coming and it still doesn’t get any better.

Spruce

Spruce (investors.hrblock.com/static-files/38796ddf-6426-460f-83e9-23f069a931da)

Features include:

  • Auto save and target goals
  • No monthly, sign-up or overdraft fees
  • Cash back offers with retailers
  • Receive your salary two days earlier
  • Ability to check your credit score for free

Features that virtually all mobile banking products offer. Here’s the argument CEO Jeff Jones makes for Spruce against its competitors in their second-quarter earnings call.

Although there are several competitors, what didn’t exist until today is a mobile banking platform from a trusted brand with 66 years of experience helping people with their silver.

Spruce bridges this gap by combining industry-leading technology and functionality, with our trusted brand and established financial relationships.

From what I understand, management relies on the H&R Block brand to differentiate products. Does anyone really believe it will make a difference whether this product is successful or not?

Internal positioning of Spruce products

Spruce’s positioning between competitors is a problem in itself. Another major issue I have with Spruce’s announcement is the internal positioning of the product which will no doubt be confusing to H&R Block customers and associates. Along with Spruce comes a new app separate from the My Block app which already has millions of downloads. The My Block app also includes Emerald Card and Savings Accounts. Keep in mind that Wave Money also has its own account.

There is no reason for H&R Block to have three banking products (5 bank accounts in total) covering three separate applications in one company. A company specializing in tax preparation. Has anyone thought of improving the Emerald card and account functionality on the My Block app instead of creating a separate app with an unrecognizable name?

Imagine you’re already a customer of the Emerald Card and Savings Account and an associate of H&R Block is trying to explain to you why you should open two new accounts at Spruce. Also, the Emerald Advance line of credit and cashback advance are not available on Spruce. Which means that H&R Block would expect a customer to maintain a minimum of three accounts (Spruce automatically opens a checking and savings account for you) to use all products offered by H&R Block. It’s unreasonable to say the least. It is becoming increasingly clear that management does not use and does not intend to use the products it offers. If they had, these issues could have been resolved before launch.

At this point, management has not released any details on how the Emerald Card and Spruce Account will co-exist. In my estimation, just as many of management’s other efforts turned out, it will turn out to be another mess that H&R customers and associates will be forced to sift through.

One advantage is that Spruce was developed in-house. From a shareholder’s perspective, it looks much better knowing that management likely saved themselves from paying 10 to 15 times a fintech’s revenue in this market.

I’ll definitely be keeping a close eye on Spruce’s progress the same way I did with Wave. Tony Bowen hinted that they are committed to transparency with Spruce’s progress. Tony even mentioned that Spruce might be split into a separate post. Management spent $450 million on Wave and we couldn’t even get that luxury or that transparency.

I would only have to assume that management expects Spruce to be a significant (per material I assume >5% long term) share of revenue going forward. In the meantime, I will personally review downloads as tax season and marketing progresses. If my prediction turns out to be correct, that shareholder capital was wasted on this project, management deserves to be held accountable.

Remember why you bought

Despite all the distractions, the long-term bullish thesis is still intact. Management reiterated FY22 guidance for median EBITDA at $800 million. Basic math (including $35 million investment) brings us to $575 million in FCF. H&R Block only trades at 7x FCF forward. That’s why I bought.

Outlook for FY22

HRB outlook for FY22 (H&R Block Investor Relations)

The current fulfillment rate of dividends paid is $177 million per year. What remains is $388 million (almost 10% of market capitalization) which will be burn a hole in Tony Bowen’s pocket. Conservatively, I think another $150 million will be used to buy back shares over the next two quarters. This is in addition to the $325 million used in the first six months of FY22. My estimate is that the number of shares by the end of FY22 will be approximately 158.5 million . This would be a 9% reduction in shares over the course of a fiscal year. Along with the generous dividend, there’s a lot for shareholders to like.

I also expect a quarterly dividend increase of $0.01 to be announced next quarter. Bringing the annual distribution to $1.12. At current prices, we are looking at a return of 4.64% next year.

EBITDA – $800 million

– D&A: $155 million

– Int. Expenditure: $95 million

– Tax expenditures (17%): $93m

Net income: $457 million with 158.5 million shares outstanding

EPS: $2.88 per share = 8.4x before p/e

Management salivates at the thought of buying back shares at 8x earnings.

Conclusion

As the first normal fiscal year approaches, it is crucial as shareholders to review deposit volumes, revenue mix and margins. Especially in the context of comparing the figures with the 2019 financial year to measure the overall impact of the pandemic on the company.

I also want to reiterate that as shareholders, the noise about Spruce is best ignored. I predict that management’s decision to launch a banking platform late, without product differentiation, and placement of questionable products will be looked down upon by shareholders in the future. Fortunately, like Wave, I don’t think it will be materially large enough to impact my long-term bullish thesis.

The company’s core operations generate enough FCF to grow high-digit profits with buybacks alone. Stay for a long time.

About Miley Sawngett

Check Also

MBS’ Credit Suisse stake isn’t just another Gulf Bank bailout

Comment this story Comment As Credit Suisse Group AG is revamped, the Saudis have stepped …