2023-10-18 12:11:12 ET
Summary
- Traditional defensive sectors such as utilities and consumer staples have not performed well in the recent market sell-off.
- H&R Block is a defensive mature business in the tax preparation industry that has historically outperformed the S&P 500 during market declines.
- HRB has a history of delivering strong results and implementing shareholder friendly dividend and share repurchase programs.
- In my view, HRB is an attractive defensive Blue Chip equity that is currently very attractive due to its valuation and strong performance.
Traditional Defensive Sectors Have Not Proved Defensive Recently
The recent market environment has proved especially challenging for a lot of stocks typically viewed as defensive. From the YTD high reached on July 27, 2023, to the recent low reached on October 3, 2023, the S&P 500 ETF Trust (SPY) has dropped by ~7%. Typically during market sell-offs, two sectors that tend to outperform due to their defensive nature are utilities and consumer staples. However, in the most recent sell-off that was not the case.
Utilities, which can be proxied with the Utilities Select Sector SPDR ETF ( XLU ) dropped more than 16%. This move lower was driven by the sharp increase in interest rates as the sector tends to be highly sensitive to interest rate moves given low growth prospects and generally high yields. Another sector typically thought to be among the most defensive in the stock market is Consumer Staples, which can be proxied with the Consumer Staples Select Sector SPDR ETF ( XLP ). The sector dropped more than 10% during the most recent broad market sell-off. The move was driven by fears the new weight loss drugs such as Ozempic, Wegovy, and Mounjaro will lead to changes in consumer behavior which may result in less demand for unhealthy products sold by the likes of companies such as Coca-Cola ( KO ), Hershey ( HSY ), and many others. Moreover, the sector tends to be a slow growth and high yield sector which means it is also susceptible to interest rate risk.
Given the challenges faced by these traditional defensive sectors, investors with limited risk tolerance should look to diversify into other defensive equities and H&R Block ( HRB ), which surged 25% during the recent market sell-off, represents an excellent opportunity to do just that.
H&R Block Is A Defensive Mature Business
HRB provides tax preparation, financial services, and small business solutions in the U.S., Canada, and Australia. ~71% of HRB's revenue comes from U.S. tax preparation. HRB provides both assisted and DIY tax software with more than 20 million returns prepared each year in the U.S. Roughly 57% of the returns prepared each year by HRB are assisted while the remaining ~43% of returns are DIY. The tax preparation industry is a mature industry that enjoys low but relatively stable growth due to increases in the number of individuals who are employed and population growth. While a recession can lead to a lower number of tax returns completed in a given year, tax preparation is an essential service for most people and thus HRB experiences limited negative impact due to broad economic weakness.
Historical Beta Analysis
As shown by the chart below, HRB's historical 3yr trailing beta to the S&P 500 has averaged 0.66 and thus the stock, on average, has shown defensive properties we would expect based on the business itself. The relatively low historical beta affirms that the business itself is less cyclical than most other businesses. However, the high level of volatility in the beta suggests that the stock is not always defensive in nature and thus additional analysis is required to better understand how HRB has performed during significant market sell-offs.
Performance During Large S&P 500 Drawdowns
To better understand HRB's ability to act as a defensive equity, investors should consider HRB's performance relative to the S&P 500 during recent stock market sell-offs. Specifically, we will analyze the 2008 financial crisis, the 2020 COVID-19 recession, and the 2022 stock market sell-off. In each case, the analysis timeframe is based off the S&P 500 high to low dates. As shown by the charts below, HRB significantly outperformed the S&P 500 during the 2008 financial crisis falling just 13.4% during a time where the S&P 500 dropped by 54%. HRB also significantly outperformed during the 2022 market sell off when it rallied 38.7% while the S&P 500 fell 23% during the same time period. During the COVID-19 sell-off, HRB dropped by 45% compared to a 33.7% drop by the S&P 500. While a number of factors likely contributed to underperformance during the COVID-19 sell-off I believe the primary drivers were related to concerns that individuals would move away from assisted services towards DIY tax preparation which is a business HRB is weaker in relative to its biggest competitor, Intuit ( INTU ) owned Turbo Tax. While no stock is guaranteed to outperform the broader market in a sell-off, the historical record suggests that HRB has been able to do that on balance and significantly outperformed during the 2008 and 2022 stock market declines while only modestly underperforming during the COVID-19 sell-off.
History of Delivering Strong Results
As shown by the table below, HRB has been able to post significant growth over the past few years despite being part of a slow growth industry. The company has benefited from a roll up strategy in which it has acquired smaller tax preparation businesses. Further evidence for HRB's strong performance can be seen in the fact that HRB shares have significantly outperformed the S&P 500 over the past five years. Moreover, HRB expects to continue posting strong growth in the years ahead due to a mix of consumer tax industry growth, pricing increases, acquisitions of smaller players, and growth in its small business services business.
Low Leverage Levels & Limited Near-Term Maturities
HRB currently forecasts FY24 EBITDA of $930 million - $965 million and the company has gross debt of $1.48 billion, cash of $987 million, and thus net debt of just $493 million resulting in a very low net leverage ratio of just ~0.5x. Low levels of leverage are important as it gives the company additional flexibility in the event of a difficult economy. Moreover, given the current financing environment low levels of leverage are particularly important in that HRB does not face a risk of a significant increase in interest costs down the road. Comparably, other defensive equities such as Verizon ( VZ ) and AT&T ( T ) have been punished by the market due to high debt levels and worries about increasing interest costs. As shown by the chart below, the debt HRB does have is relatively long maturity with 500 million coming due in 2028 and 650 million coming due in 2030. Given HRB's current cash balance and ability to generate free cash flow, the company would likely have the option to not roll the financing forward and instead pay these notes down with cash from the balance sheet and cash generated from the business.
Valuation
As shown by the chart below, HRB is trading at just 10.2x June 2024 estimates earnings. This compares to a forward PE ratio of ~18x for the S&P 500. While the S&P 500 is expected to grow earnings by closer to 12% next year, HRB is expected to grow earnings by just 9.4%. Thus, the forward PEG ratio of HRB is 1.08 compared to 1.5x for the S&P 500. On this metric, HRB compared quite favorably to the S&P 500 on a valuation basis. The valuation discount is even more significant when considering the relatively defensive nature of HRB's business and lack of cyclicality. An argument can be made that a high quality business such as HRB should trade at a PEG premium to the S&P 500 given the lower beta nature of the stock and thus I view the current valuation as highly attractive for HRB.
Shareholder-Friendly Capital Allocation Policies
As shown by the charts below, HRB has been a routine dividend grower. The quarterly dividend was increased 10% in August to $0.32 and the stock currently yields close to 3%. Moreover, HRB has also used share repurchases to return capital to shareholders with the share-count having dropped to 146 million today compared to just under 400 million shares as of 2000 and just under 200 million shares as of 2020. Currently, the company has remaining authorization to buy back up to $700 million in shares which is effective through FY 2025.
Conclusion
HRB's primary business of tax preparation services is recession resilient as most individuals will still need to file taxes regardless of economic conditions. While higher rates of unemployment can lead to a temporary drop in the number of returns this is only temporary in nature. HRB's beta and historical performance during recent broad market sell-offs confirm the recession resilient nature of the business. In addition to its defensive properties, HRB is still able to achieve EPS growth in the high single digits due to pricing power, consolidation, and growth in its business services segment. Despite being a recession-resilient business with high-single-digit EPS growth, HRB trades at a forward PEG ratio of just 1.08 which is very attractive relative to the S&P 500 forward PEG of close to 1.5. HRB benefits from a strong balance sheet and has implemented a shareholder-friendly capital allocation policy with significant dividend growth and share repurchases historically.
Overall, HRB represents an attractive defensive Blue Chip stock in a stock market when many traditional defensive stocks have lost their defensive properties for a variety of reasons. As such, I view HRB as a very attractive building block to any defensive equity portfolio right now.
For further details see:
H&R Block: A Defensive Blue Chip Buy