2023-04-05 14:49:54 ET
Summary
- The good potential behind digitization efforts can attract young, tech-savvy customers.
- The company seems to be resilient during downturns, as I did not see much indication of the contrary.
- The company's ability to generate good free cash flow and reward its shareholders is the main reason it will succeed in the future, in my view.
- An outstanding balance sheet is a good enough reason to invest.
- A conservative 10-year DCF model suggests the company is a buy at these levels, however, caution is necessary during current volatility.
Investment Thesis
With Q2 results beating estimates, I wanted to have a look at H&R Block (HRB) to see how the company may perform in an economic downturn. The company is yet to see its strongest quarters for the year, coupled with good financial health and an ability to generate good free cash flow, the company seems to be positioned well in case of an economic downturn and is a buy at these levels. Furthermore, a 10-year DCF model with assumptions of decreasing revenues in the next two years still suggests the company has room to grow.
Latest Quarter Results
The company may seem unprofitable when looking at it quarter by quarter, especially if those quarters are not in the tax season. The latest quarter was just that, EPS came in at $-1.37, and revenue came in at $166.41m. Both beat analysts' estimates and the management seemed very happy with the quarterly performance. The management reiterated topline growth and EBITDA to outpace revenue while EPS to grow even faster, in the double digits. The management appears to be seeing only positives for the company in the future.
Outlook
The company has implemented some initiatives that could provide decent growth in the future. I like the idea of getting Spruce to be implemented further into the echo system. The banking app stands out to me because it has zero fees, a locator for fee-free ATMs for money withdrawal, FDIC backing, and soon, the ability to make Spruce account your main bank for payrolls. The company is improving its digital footprint, and this will certainly attract the younger generation of workers, who like me, prefer to do their banking on their phones.
The company has many offices globally which serves well for people who still would like to come in and figure out their taxes in person with a tax advisor who can help educate them on their tax returns and other tax-related services. This is an advantage to H&R Block compared to an online-only tax company like Intuit (INTU). It does mean that the margins the company can achieve are much lower than the ones of INTU, however, HRB is able to attract a more diverse type of customer who may not be technically savvy as the younger generations. HRB is positioned well to serve the old and the younger generations in the future as they are focusing on digitization.
The company has not seen much revenue growth throughout the years. In the last ten years, the company grew its topline by only 19%, which suggests that the company will not grow any quicker during the next ten years either. The tax industry historically performed quite well during economic downturns. For example, when the unemployment rate was around 10% in April of 2010, the company experienced only a 5% decrease in revenues, a year before that the revenues were pretty much flat, suggesting that revenues do not depend on how many people are in the workforce. I would argue that during the harder times, people who are experiencing difficult times will seek out HRB's services so they can get as much as they can from their tax returns for the year. Unemployment rates are predicted to reach around 4.5% once the inflation cools down and interest rates stop increasing and start stabilizing. I believe revenues will not be affected a lot when the unemployment rate hits 4.5%, because in 2010 the unemployment rate was more than double that and the company only lost 5%.
I believe the company will perform quite well in the future and will not see much volatility in its performance. Another interesting fact is that when there is higher unemployment in the economy, there seems to be an increase in new business startups which will benefit HRB as they serve small businesses. I share the same sentiment as the management and believe that the company will be just fine in the next 12-24 months, even during a potential recessionary period.
Financials
The latest quarter showed cash on hand to be around $292m including restricted cash. Looking at y-o-y historical figures, FY2022 showed $885m of cash on hand. It makes sense that the company has much lower cash right now as these quarters are historically unprofitable and the company must use the available cash to fund its day-to-day operations. On top of that, the company also took on an extra $750m of debt through its credit facility and repaid $170m of previous debt, giving a net increase in debt of $580m from the last annual report. The company does have a lot of debt, however, I don't see this as being problematic on an annual basis as the company has plenty of cash and operating income to pay off the interest expenses annually.
The company doesn't seem to have problems repaying its short-term obligations as the current ratio is well above 1 historically, although, it seems to be in a downtrend, which if continues, may present a red flag in the future. For now, it is still acceptable.
In terms of profitability and efficiency, the company seems to be quite healthy and manages to return decent value to the shareholders. ROA has been well above 10% in the last 5 years, except for 2020, while ROE is rather very inflated due to the company's use of debt and stable repurchasing of shares.
We can see a similar situation on return on invested capital. The management can effectively spend its money on profitable investments to increase shareholder wealth. It is well above my minimum of 10% ROIC, which also suggests the company has a competitive advantage and a decent moat compared to other companies. Compare ROIC to a company like Intuit, HRB's ROIC is more than double that of Intuit.
Overall, the company's books suggest that with a downturn in the economy, it is well positioned to weather it and will not see many problems in covering its short-term obligations while maintaining a good moat and competitive advantage over the competition. The balance sheet alone could entice people to invest in the company, however, timing can ruin the potential returns if buying at the wrong time. So, let's look at what we should pay for such a healthy balance sheet and future growth potential.
Valuation
HRB manages to generate very decent free cash flow, and I would argue that if the company continues as it has in the past, coupled with the great balance sheet, the company is a good contender for a long-term investor.
For the model, I wanted to show that even a revenue decline is likely not going to be an issue for HRB. I will also keep the margins as they are currently, even though the company managed to improve them over time, albeit with a lot of volatility.
For the base case, I'd like to assume -a 10% decrease in revenues in '23 and -5% in '24 to reflect a recessionary period, followed by a slight increase in revenues of 5% that linearly decline to 3% growth by '32. These assumptions show a 17% increase in revenues from FY2022, which coincides with the previous 10-year revenue increase of 19% as I mentioned earlier (2013: $2.9B to 2022: $3.4B)
For the conservative case, I kept it simple and decreased every period by 200bps while for the optimistic case, I increased the growth by 200bps.
The company saw a slight contraction in margins at the end of FY2022. I decided to keep these worse margins rather than go back to the prior year's margins, which were healthier by around 300bps on gross margins and 500bps on EBITDA margins. This way my model would be more conservative and provide a better margin of safety. Furthermore, I will also add a 25% margin of safety on the intrinsic value calculation to give me even more safety. 25% is the bare minimum I like to add to companies, and seeing that the company has a very good balance sheet, I believe it will be sufficient.
The 10-year DCF model with all the assumptions and implied 25% margin of safety suggests the company is currently undervalued with an upside of 42.3% from current valuations.
Closing Remarks
The company is a buy if you believe the assumptions above are reasonable and if you believe the company is resilient and will generate good value for its investors. The big risk right now that may distort the company's valuation in the short run is the volatility that we will see in the next 12-24 months. The volatility may bring down the share price even further. As of writing this article, the company went down over 3% on no apparent news whatsoever. I would expect to see further volatility in the upcoming months. For the long-term investor, the company is a great buy and if the person is not put off by the current volatility it wouldn't be a bad time to start a small position right now and average down if the company drops further, which it may. I am quite patient when it comes to volatility and will wait to see what happens over the next couple of months before I pull the trigger on this one.
For further details see:
H&R Block: Resilient To Downturns, Good Long-Term Buy