2023-04-21 02:54:32 ET
Summary
- During recessions, high inflation, and bear markets, selling covered calls can increase your cash income stream, while hedging some downside in price.
- H&R Block is a smart buy-and-hold target today, with a low valuation and stable business results.
- Call option premiums can also be captured to push your total annual cash yield into the 7% to 20% range (depending on which options are sold).
H&R Block ( HRB ) has experienced a rather large selloff since late summer, dropping from $48 in August to $33 a share this week. Today, it is returning a nice cash dividend yield of 3.4% with an indicated $1.16 annual payout. The distribution yield is more than double the S&P 500 rate of 1.5%. Such provides a solid income proposition for investors, but I suggest a simple active-management strategy to double, triple or more your cash returns, without taking on extra risk, or giving away an exaggerated amount of future price appreciation.
The company’s steady and regular business results, garnered as the top income tax return preparer for individuals and small businesses, makes it a great candidate for selling covered calls on your long position. In fact, being able to purchase this name with a forward P/E of 8x, at valuation ratios in the normal to undervalued range vs. the last decade of trading history, opens all kinds of avenues to create smart cash yields and total return potential over time.
If you are hunting for a low-risk buying opportunity in the U.S. equity market, that can deliver immediate income into your pocket from both a standard dividend payout and the selling of covered calls to capture today's higher-than-normal premiums on Wall Street, HRB stock could be a productive idea to research for your own account.
The Value Buy Story
H&R Block has a history over the last 10-20 years of 5% to 10% yearly gains in sales and earnings per share, slightly beating the rate of inflation over time. It has not been a high-growth name since the early 1990s. Consequently, a lack of investor interest has translated into a very advantageous upfront valuation for new share accumulation over recent years.
The standout data point to ponder right now is the basic price to earnings valuation. Reviewing its trailing P/E around 11.7x income generated before the end of this income tax filing season, or the 8.1x projected multiple for next year, HRB is far and away valued at a huge discount to equivalent S&P 500 projections in the 17x to 22x range. In addition, the P/E valuation used to place in the 15x to 20x zone for the company a decade ago, when similar growth prospects existed.
YCharts - H&R Block, Trailing & Forward Estimated P/E Ratios, Since 2013
You will notice the pandemic closures of physical locations were hard on the tax preparation business, especially with H&R Block storefronts usually found in high-traffic spots close to general retail. During 2020 HRB operated near breakeven for profitability, with 2021 only seeing mild improvement. Finally, by fiscal 2022 (ended in June), business results approached the pre-COVID levels of 2019. Wall Street EPS forecasts highlight a continued uptrend this year and next.
Seeking Alpha Table - H&R Block, Wall Street Estimates for 2023-24, Made on April 19th, 2023
In terms of how the business has been managed, the company used to hold little debt compared to cash on the balance sheet. This changed in 2016 as cash on hand, cash coming in the door, and some extra debt has been used to finance share buybacks. Since 2015, better than 40% of shares have been retired, with outstanding counts falling from 275 million nine years ago to 159 million today. In the end, both sales and EPS have doubled over the last decade, a 7% compounded advance rate for long-term owners.
YCharts - H&R Block, Total Debt minus Cash Holdings, Quarterly, Since 2013
The good news is debt-service interest expense has not handcuffed business operations. Presently, cash flow ratios vs. sales and debt are running at a better clip than 2013 and above 10-year averages. [I would note using cash flow in 2023 to pay down debt would help derisk the business going into a recession. That would be my plan if running the organization.]
YCharts - H&R Block, Cash Flow to Sales/Debt, Since 2013
When you include debt and cash fluctuations on the balance sheet, enterprise value readings have been relatively consistent over the decades. EV calculations to forward EBITDA (earnings before interest, taxes, depreciation/amortization) of 7.5x and revenues of 2.0x for fiscal 2024 are sitting near the midpoint of long-term averages, if not somewhat lower.
YCharts - H&R Block, EV to EBITDA & Revenue, Since 2018 YCharts - H&R Block, EV to Trailing EBITDA & Revenue, Since 1986
Lastly, the trailing dividend yield of 3.4% remains at a generous level compared to the general stock market. Plus, the 2.6x and higher dividend cover from earnings since early 2022 (likely to rise in 2023-24) is the most conservative in years. My view is management can/will raise the dividend markedly in future years, assuming earnings estimates from Wall Street prove correct.
YCharts - H&R Block vs. S&P 500 ETF, Dividend Yield, Since 2013 YCharts - H&R Block, Trailing Dividends Paid, Earnings Coverage Ratio, Since 2013
Still Positive Technical Momentum
Another reason to like H&R Block is the momentum picture remains quite bullish, despite the 30% price drop over eight months. On the chart below you can review how each of the Accumulation/Distribution Line , Negative Volume Index , and On Balance Volume indicators are now HIGHER than witnessed at the $48 August price peak.
It is incredibly rare to see these underlying health signals stand up in unison to a prolonged and material price decline. My read of the situation is eventually a good news reason to buy will show up, and shares will rebound significantly in price. One catalyst might be the next earnings/sales release in early May.
StockCharts.com - H&R Block, 2 Years of Daily Price & Volume Changes
The Option Selling Strategy
Waiting for a major share price advance, why not jump your cash income through the selling of covered calls?
My thinking is H&R Block’s stability and predictability in operations presents a perfect candidate for a covered-call selling plan. Extra returns of 4% to 25% annually can be achieved selling out-of-the-money call options every 2-3 months (or shorter or longer time periods if you wish). Below is a graph of today’s bid/ask spreads in the July 2023 contracts for an expiration.
Seeking Alpha - H&R Block, Option Pricing Table, April 20th, 2023
For example, you can capture $1.50 per share (splitting the bid and ask) every three months selling the slightly out-of-the-money $35 strike price. That works out to nearly 18% in extra yield over the course of one year (not counting trading commissions and expenses), added to the $1.16 in anticipated dividend distributions for a 21.5% cash return in your pocket. Plus, another 4% or so in capital appreciation gets you to the out-of-the-money strike price, where you risk losing your position to the call buyer (you do have the ability to cover the option position before expiration). All told, a rapid rebound in HRB by July gives you the chance to earn a better than a 36% annualized total return profit (9% over less than three months), in a best-case scenario!
A secondary angle to keep more potential price upside is to sell a strike price further out. For example, writing a $39 strike nets you about $0.40 every three months, while retaining the ability to grab over $5 in price appreciation. As long as HRB’s quote remains below the strike price, you get to keep the call premium and dividend, creating a rough 8% yield annually. Given a $40 stock quote in a bull rebound for the stock, you could pocket almost $6 per share in total on this strategy, for a better than 72% annualized gain (18% over three months)!
The main risk of this covered-call strategy is you hold all of the downside in the stock should price continue to decline. However, falling share quotes should also allow you to repurchase the call option at a lower price, netting some bit of hedge overall. That’s why covered call writing is considered an even safer investment plan than holding a long-only stake, at least in terms of combined net downside risk.
Plus, an opportunity cost does remain. You will limit the potential for large gains to the overhead strike price. If HRB gets to $50 next year, you may feel the sting of abandoned price gains. You have not lost any money per se, but the opportunity for outsized net profits is given to the call buyer.
When all is said and done, individual investors must decide for themselves what level of upfront income is worth letting go of future upside. Yet for me, H&R Block’s current investment setup provides an excellent opening to execute a call-writing strategy.
Final Thoughts
Another reason to like H&R Block is the tax-preparation business model is relatively recession-proof. The company has survived the ups and downs in economic expansion and contraction just fine. As long as we all use tax preparers and the income tax code remains a hard-to-understand maze of changing regulations and laws, I am confident HRB's in-person consulting and personalized appointment model will continue to be a winner. Sure, online competition for tax preparation and a few knock-off franchised store peers will take their share of consumer demand. But, plenty of room exists for all of them in the marketplace. Hundreds of millions of returns are made annually in the U.S.
Seeking Alpha's Quant Ranking of earnings and technical share trading momentum also concurs with a bullish take on the stock around $33. Effectively in the Top 10% of all U.S. stocks sorted on the same criteria, H&R Block can be argued as a worthy buy candidate.
Seeking Alpha Table - H&R Block, Quant Ranking, April 20th, 2023
Then, when you increase your cash income stream through writing covered calls, the investment concept takes on added appeal. In this high inflation world, with interest rates and dividend yields still lagging cost-of-living jumps, why not consider owning a stable business with a high/rising cash dividend payout, that can easily be upsized into a stronger income stream bracket through several option trades each year? 7%, 10%, 15% and greater cash returns are possible with the right design, absent the use of leverage or entering a risky/exotic trading game.
Can this plan be executed in other stocks? Absolutely, and now may be a great time to contemplate such. A recession and extended waves of selling on Wall Street can be hedged through covered-call writing. The call premiums provide an offset to future equity price declines, potentially slashing losses in your brokerage account. My question for you is why not entertain the idea of extra income and an efficient hedge setup in April 2023?
Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.
For further details see:
Turn H&R Block Into A High Yielder, Selling Covered Calls