Wednesday, January 14, 2009

Taking Stock in H&R Block

Bloomberg News reported an interesting fact about H&R Block, the country's largest tax preparer. H&R Block's chief executive, Russell Smyth, expects to have over $1 billion in cash by April, driven by consumers' desire to maximize tax refunds in a deteriorating economy. This is a marked turnaround from a year ago, when H&R Block took $1 billion in losses from a subprime mortgage unit, which was subsequently acquired by the financier Wilbur L. Ross.

H&R Block piqued my interest when I saw their services being prominently advertised in a Sears store, which I mentioned in this
recent article. The company is very impressive, primarily for its first-class economics. As CEO Russell Smyth said, "We are in a cash business and we’ll have a lot of it at the end of this fiscal year. That’s a tremendous competitive advantage because we’ll be able to make great strategic choices about what to do with that money."

In fact, Warren Buffett was the second-largest shareholder in H&R Block beginning in late 2000 and early 2001, riding a handsome run-up in the stock price. Buffett sold his stake in 2007, probably due to H&R Block's diversification away from its core business, as well as its exposure to subprime.

But what did Buffett initially see in the company?

First, H&R Block fits the classic Buffett mold: founded by visionary entrepreneurs Henry and Richard Bloch, the family remains active in the business unto this day.

Second, the fact that H&R Block is a tremendously profitable "cash business," as its current CEO kindly reminded us. H&R Block's five-year average ROE is nearly 25%, with very little capital reinvestment needs. In other words, the company consistently generates impressive free cash flow, from a business that is both fundamental and predictable.

Third, relative to its size, H&R Block has no major competitors. It is a consumer monopoly, another Buffett hallmark. The closest competition appears to be Jackson Hewitt, with a market capitalization of $400 million, relative to H&R Block's towering $7 billion size.

As a measure of H&R Block's dominance, it generates roughly $700 million in EBIT off a roughly $990 million equity base. By contrast, Jackson Hewitt generates a mere $66 million in EBIT, off a $236 million equity base. In other words, H&R Block operates using about four times the equity of Jackson Hewitt, yet H&R Block reaps over
ten times the pretax profit!

There is no doubt that H&R Block is a unique and impressive business. And with shedding its mortgage division and refocusing on core lines of business, H&R Block could represent an attractive candidate for acquisition.

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This work by Nicholas E. Radice is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.