2023-12-21 02:26:26 ET
Summary
- H&R Block is a leading business in the tax industry, utilizing its strong brand and deep expertise to generate highly attractive margins.
- Management utilizes this to distribute to shareholders, with over 40% of diluted shares repurchased.
- Management has taken good actions to improve the company's growth trajectory, which we suspect will work (although not to the top-end expected), allowing for an acceleration of returns.
- HRB stock is trading at a deep discount to its peers despite outperforming on margins, suggesting clear upside. This said, investors should be warned its valuation is broadly in line with its historical average (from an EBITDA perspective). The key factor for us is its FCF yield, which is ~11%.
Investment thesis
Our current investment thesis is:
- HRB is a leading business in the tax industry, utilizing its strong brand and deep expertise to generate highly attractive margins. Management utilizes this to distribute to shareholders, with over 40% of diluted shares repurchased.
- Management has taken good actions to improve the company's growth trajectory, which we suspect will work (although not to the top-end expected), allowing for an acceleration of returns.
- HRB is trading at a deep discount to its peers despite outperforming on margins, suggesting clear upside. This said, investors should be warned its valuation is broadly in line with its historical average (from an EBITDA perspective). The key factor for us is its FCF yield, which is ~11%.
Company description
H&R Block, Inc. ( HRB ) is a prominent American tax preparation company headquartered in Kansas City, Missouri. Founded in 1955, it offers a range of tax-related services, including assisted and DIY tax preparation, financial products, and business services. H&R Block operates in the United States, Canada, and Australia.
Share price
HRB’s share price performance has been respectable during the last decade, with the majority of its gains generated post-pandemic. The recent improvement is a reflection of the company’s financial development and the scope for increased returns in the coming years.
Financial analysis
Presented above are HRB's financial results.
Revenue & Commercial Factors
HRB’s revenue growth has been mediocre during the last decade, with a CAGR of 2%. Further, the company’s growth has been volatile, with 4 periods of negative growth.
Business Model
HRB is best known for its tax preparation services, which help individuals and businesses navigate the complex process of filing taxes. This includes preparing and filing federal and state tax returns. The filing of taxes in the US is an important milestone annually, with punishments for late/incorrect filings but also good scope for refunds, as ~75% of filters receive a refund from the IRS ( Source: IRS Publication 1304 ). This ensures consistent and growing demand for HRB’s services.
The company operates a network of physical retail offices, where customers can visit in person to receive tax assistance. In addition, H&R Block offers online tax filing services, allowing customers to prepare and file taxes from the comfort of their homes. We suspect there is scope for transitioning toward its online services relative to physical locations, as technological adoption develops. This could support a reduction in costs, particularly if the company can utilize low-cost support staff.
Furthermore, HRB offers various financial products and services, including refund anticipation checks (RACs), prepaid debit cards, and small loans. These services are often targeted at individuals alongside the core tax services they provide. This expansion allows the business to utilize its brand to expand its relationship with clients, contributing to increased revenue and diversification. Additionally, given the timing of tax season annually, this allows for a smoother revenue profile.
HRB has supplemented its organic growth trajectory with acquisitions, acquiring a range of businesses including Wave, with almost $1bn spent in the last decade. We would like to see this activity increase in the coming years, given the fragmented nature of the industry. This would take some cash away from distributions but long term, would allow for better growth to further propel the company.
Management’s current strategy involves the following three strategic imperatives:
- Small Business - Build and develop relationships with Small Businesses through Block Advisor and Wave, as well as providing services such as bookkeeping and payroll.
- Financial Products - Provision of financial services, supported by the Spruce business.
- Block Experience - Utilizing technology and human expertise to serve clients.
The Small Business segment is growing well, primarily through the expansion of its services and focus on new customer wins. Management expects much of the gains are yet to come, considering it is still in the growth phase. Block Advisors grew +6% YoY, with Wave growing +6% also.
Further, the Financial Products segment is earlier in its growth trajectory, with the recent launches of its mobile banking platform. Initial feedback on this is positive, with scope for strong growth. The segment currently has >300k sign-ups and ~$400m customer deposits.
Finally, Block Experience. This segment is the most vague but has the potential to be equally as lucrative. The key for us is how Management utilizes technology to streamline the business. HRB has announced a partnership with Microsoft ( MSFT ) to incorporate Azure OpenAI and genAI into its operations. We believe the scope for improvement is high, given how labor-heavy the company is and how “traditional” it is in the way it operates.
These three factors, supported by the underlying quality of the business and its legacy operations, are expected to improve the company’s growth trajectory, with Management targeting 3-6%. We suspect improvement is likely, although closer to the 3-4% level than 6%, primarily due to the high level of competition within these various industries. Although HRB has a strong brand, it is not doing anything revolutionary.
Tax/Financial Support Industry
The primary reason for HRB’s weak growth trajectory is the wider industry, which is developing at a snail's pace. This is unsurprising given the slowing population growth, slowing salary growth, and the stagnation in employment levels.
In conjunction with this, HRB faces intense competition in the tax preparation industry, not only from other tax preparation firms but also from software companies that offer DIY tax preparation software. Online tax filing platforms have become increasingly popular, challenging H&R Block's traditional business model. Examples include Intuit’s ( INTU ) TurboTax.
The shift toward digital and online services has been the biggest factor challenging the company’s competitive position. It has responded well through innovation but nevertheless has eroded its market-leading position and ability to extract greater value from its service.
Changes in tax laws and regulations can impact the complexity of tax preparation, meaning the company must maintain and develop its expertise every year, contributing to increased costs associated with training and employment.
The availability of information and ease of use of DIY tax software have encouraged some consumers to file their taxes independently, reducing the need for professional tax preparers. The risk here is that consumers transition toward lower-margin products or competitors, due to the belief they possess the required expertise.
Margins
HRB’s margins have been relatively flat during the historical period (excl. the covid-19 impacted year where cost pressures depressed margins), although are slightly lower than what was achieved historically on an EBITDA basis, owing to a change in product mix. The consistency of its margins illustrates the resilience of HRB’s business model and its competitive positioning.
We do not believe it is reasonable to expect improvement in the coming years, however, we expect the current levels to be sustainable.
Balance sheet & Cash Flows
The attractiveness of HRB can be seen in its BS and CF. The company has aggressively utilized FCF to repurchase shares and distribute to shareholders, contributing to an impressive yield for existing investors.
Importantly, the FCF margin has shown itself to be consistent, with little variability which implies a continuation of this is likely.
As the following illustrates, the number of diluted shares has declined by over 40% during the period while dividend yield has been consistent.
Outlook
Presented above is Wall Street's consensus view on the coming 5 years.
Analysts are forecasting a continuation of the company’s mild growth trajectory, with a CAGR of 2% into FY26F. Margins are also expected to remain broadly flat. Both assumptions appear reasonable based on the company’s historical performance, although we do see scope for upside beyond this should its recent expansionary efforts materialize as Management expects.
Industry analysis
Presented above is a comparison of HRB's growth and profitability to the average of its industry, as defined by Seeking Alpha (9 companies).
HRB performs well relative to its peers. The company’s key strength is its margins, with a notable premium. This is a reflection of HRB’s strong market position, allowing the business to price aggressively. This translates directly to FCF, which has allowed the company to aggressively distribute to shareholders.
The company’s growth is closer to its peer group’s average, which is expected given the maturity of the industry, restricting the company’s ability to significantly outperform. This said, it is impressive to see that HRB can still grow broadly in line with the average despite the increase in competition.
Valuation
HRB is currently trading at 9x LTM EBITDA and 8x NTM EBITDA. This is a small premium to its historical average.
Our view is that HRB warrants a premium to its historical average (10-20%), primarily due to the development of its current business model, the increased scope for distributions through scale, and its success with maintaining its competitive position. On an EBITDA basis, this does not imply substantial upside.
Further, a comparable valuation to its peers is likely reasonable, as this would reflect the company’s margin superiority but also its lack of growth. Based on this approach, there is substantial upside, given the steep discount HRB is trading at. The discount is likely a reflection of investors’ sentiment toward HRB’s lack of growth, overly depressing its trading valuation (which has been the case for most of the decade).
As the following illustrates, HRB’s valuation has broadly traded flat, suggesting the scope for upside is limited, and only likely through growth.
This said, it cannot be understated how attractive its distributable potential is, weighting our assessment toward HRB being attractively priced. With a yield in excess of 10% and a Management team in favor of aggressively distributing, investors are extremely likely to see a positive trajectory.
Valuation evolution (Capital IQ)
Key risks with our thesis
a risk to our current thesis is:
- Execution risk. HRB’s desire to expand its service offering represents execution risk, particularly due to its expansion into markets that are competitive. The downside is not significant but involves financial investment and time.
Final thoughts
HRB is a high-quality business. The company has a strong market position in a resilient, growing (although slowly) industry. Its deep expertise and strong brand allow the business to earn high margins, much of which directly translates to FCF. Management has used this to directly reward investors, with a continuation of this trend expected.
The expansion of its services and, particularly, its investment in technological capabilities has the potential to improve growth, while also protecting margins.
HRB’s valuation is less clear-cut for us, given the alignment to its historical average (both at an EBITDA level and FCF yield) but significant discount to its peers. This said, we believe the absolute yield is the most important factor given the distribution strategy, and this is highly attractive.
For further details see:
H&R Block: Upward Trajectory In Progress With Value Likely Ahead