By Ben Strubel of Strubel Investment Management
H&R Block (HRB) is the largest tax preparer in the United States and prepares roughly one out of every seven tax returns filed. The company was founded in 1955 and has prepared 550 million tax returns since then. The company also offers consulting and accounting services through a small subsidiary, RSM McGladrey.
Over the past few years, HRB saw its share of the tax return market shrink. It moved into the mortgage and financial planning and investment products markets. Both moves turned out to be disastrous, with HRB getting caught in the subprime mess and selling its mortgage unit. The financial planning business also ended poorly with a flurry of lawsuits and the business being sold to Ameriprise. In 2007 after a proxy battle by Richard C. Breeden, a hedge fund manager and former SEC chairman, the previous CEO resigned. Former McDonald’s executive Russell P. Smyth was brought in. Last year Smyth left the company and HRB installed Alan Bennett as CEO.
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HRB stock has dropped because the company is perceived to be under threat from three major items: (1) the loss of funding for Refund Anticipation Loans (RALs), (2) the growth in market share for TurboTax and other digital solutions, and (3) mortgage putbacks from its legacy mortgage origination activities.
Loss of RAL Funding
HRB stocked dropped precipitously when HSBC announced it was backing out of an agreement to fund RALs for HRB. HRB sued, but the stock fell even further when the Office of the Comptroller of Currency stepped in and banned HSBC from providing RALs.
As shown by the chart below, RAL and RAC fees (under the other category) make up 10% at most of revenues for HRB.
The biggest fear at the time seemed to be that the loss of RALs would lead customers to go to competitors who could offer RALs. The reality of the situation was different. It turns out there was just not a lot of RAL funding out there, although some competitors will have RALs that will not be nearly enough to meet the potential demand. HRB also offers numerous refund products that can take the place of RALs, including Refund Anticipation Checks (RACs) and various Emerald Card products. According to management, the RAL-to-RAC conversion will be neutral from an income standpoint.
Additionally, with the FDIC informing Republic Bank & Trust in February to exit the RAL business, it seems that the government has made it clear that RALs are no longer welcome in the marketplace and we are likely moving to a future where no tax preparer is able to offer RALs.
Digital and TurboTax
Many, including some sell-side analysts, have put forth the idea that H&R Block’s core business of tax preparation is in decline because of do-it-yourself at-home or online software, specifically TurboTax. Indeed, almost any media article about H&R Block mentions the company is losing market share to TurboTax. With TurboTax (or other digital solutions) gaining market share and HRB’s market share declining, many have simply assumed the two are related. This is not the case.
The chart below shows the percent of income tax returns filed using a paid preparer for that tax year.
(Source: IRS data, Forbes, and H&R Block company presentation)
Since the 1996 tax year, the percent of filers using a paid preparer has increased. The drops in 2003, 2007, and 2008 generally correspond to higher unemployment and or greater job or economic uncertainty. Also keep in mind that TurboTax debuted in 1983 and was bought by Intuit in 1993, so digital solutions have been in the market for the entire time period shown.
Instead of hurting HRB, the data shows that TurboTax and other digital solutions have been making large gains in market share at the expense of old “pencil and paper” filers. HRB’s core market of assisted tax preparation is growing. The real reason for HRB’s loss of market is due to a combination of poor service and higher unemployment. While the customer service issue is easily corrected, the greatest long-term threat is continued high unemployment.
The largest short-term threat to HRB is mortgage putbacks. Mortgage putbacks occur when mortgage buyers force the mortgage originator to buy back the loan, typically due to misrepresentation or fraud. In order to attempt a putback, investors in the mortgages must gather 25% of the voting rights. HRB originated mortgages up to December 2007 via a subsidiary called Option One (now called Sand Canyon Corp or SCC). In 2008 HRB sold SCC to American Home Mortgage Servicing; however, HRB is still liable for any representations and warranties on mortgages originated by SCC while part of HRB.
The chart below shows the mortgage balances outstanding for mortgages originated from 2005 to 2007, which were the problem years. HRB has received almost no putback claims for mortgages originated outside that time period.
(Source: company presentation)
Understanding the Putback Threat
The threat of putbacks varies by the type of investor who bought the loans as well as the type of loan that was originated and the representations and warranties made by the originator. The mortgage investors can be broken down into four main types: GSEs, Private label securitizations, whole loan investors, and monolines. HRB’s quarter-to-date mortgage putback claims are shown below, broken down by counterparty type.
(Source: company presentation)
For other mortgage originators GSEs have been the most active in putting back mortgages. The representations and warranties made to loans sold to GSE are the strongest, and the GSEs have slightly different standards for initiating putback claims than other investors. However, GSEs pose the smallest threat to HRB. SCC sold only approximately $500M worth of loans to FNMA. To date HRB has received claims totaling only $13M from GSEs. Putbacks by GSEs have been sporadic throughout 2009 and 2010 and show no signs of increasing.
Some securitizations were sold with insurance “wrappers” where monoline insurance companies agreed to insure portions of the security against default. Like GSEs, monoline insurers have been very active in pursuing putbacks. There are at least two differences, however, between monolines (and private label and whole loan investors) and GSEs. First, SCC is only obligated to repurchase loans for an evidenced breach of representations and warranties that has adversely affected the loan. Second, the reps and warranties for monoline-insured loans were generally more discriminating than for GSE loans1. Here again HRB has little exposure with only $2B in loans having been sold with insurance.
Whole Loan Investors
Whole loan investors make up a small portion of overall loans at only $2B. Many loans sold to whoe loan investors included an early default provision whereby if a borrower defaulted on the first payment SCC was required to repurchase the loan. To date SCC has repurchased $1.3B in loans. However, the early default provisions have expired. There were some other reps and warranties provided that were not subject to a stated term. Altogether put backs from whole loan investors have steadily declined
Private Label Securitizations
Private label securitization investors previously were not very active in pursuing putbacks. This was mainly due to the difficulty of securing 25% of the voting rights before the investors could ask the trustee to review the loan files to begin a putback claim. Also, the individual investors would need to bear the cost of any legal action. Finally, representations and warranties were much more discriminate than on GSE and monoline loans. Loans also tended to include extensive disclaimers and were generally not presented as investment quality. However PLS investors have now become more active in joining together to pursue putback claims. The worry is that these claims will be successful and the liabilities will begin to mount for HRB. A vast majority of the loans SCC originated, $39B, were sold as PLS with no monoline insurance. And, as in shown in the chart in the introductory section, PLS putback claims have now started appearing in 2010 and 2011 after having been absent in 2009.
Why the Putback Risk is Overblown
While PLS putback claims are likely to rise, the risk is likely overblown. A recovering stock price seems to point to investors realizing that.
No Doc (or Low Doc or Stated Income Loans) Were Disclosed
SCC originated a large portion of no or low doc loans and one misconception is that a borrower who is lying is grounds for a putback claim. This is generally not the case. For instance, say SCC originated a no doc (or low doc or stated income) loan where the borrower was not required to provide proof of income. When SCC sold the loan to a third party, if it disclosed that no proof of income was obtained and made no representations or warranties about the information provided by the borrower, then SCC is not liable to take back the loan if it is discovered that the borrower lied to obtain the loan.
Time Is on Investors Side
As the mortgage pools age, it becomes increasingly difficult for investors to make the case that loan noncompliance with underwriting standards was the cause of defaults and not economic factors. Also, as time goes by the outstanding mortgage balance continues to fall. Additionally, putback claims and payments happen over several years. HRB generates high amounts of free cash flow. Should paid claims overwhelm HRB’s mortgage loss reserves, it will have cash on hand to cover them. The situation is similar to tobacco companies that have been forced to pay out large damages claims but are paying those claims out over long periods of time rather than all at once.
No Ongoing Relationships with Buyers
Finally, there is one other important issue that is overlooked. Now that HRB is not in the mortgage origination business, it has no incentive to maintain good ongoing relationships by making policy adjustments to placate any mortgage buyers. Other banks still in the mortgage business have often been striking deals with investors. HRB has no incentive to relax any standards to placate buyers.
Improving Customer Service & Brand Recognition
As we saw above, HRB is not losing customers to TurboTax or other digital solutions. Instead, the company has lost customers to other tax preparers through its years of mismanagement and poor customer service. Luckily, fixing these types of problems are some of the easier ones corporations face. HRB still offers a service, assisted tax prep, which customers want to use. HRB just has to figure out why the customers have left and what can be done to bring them back.
Some highlights of the new customer service and advertising programs include the following:
- Free coffee is back
- Staffed 34% more hours
- More training for staff
- Started to measure tax pros by client retention
- Allow clients to work with same tax pro each year
- More training for staff
- Issue resolution and satisfaction scores have been trending higher
Free Federal 1040EZ Filing designed to:
1. Entice potential clients to try HRB risk-free
2. Build relationships with 18-35 year olds who then come back in later years with more complicated returns.
3. Up sell.
Based on preliminary tax season results released by HRB the campaign and improvements seem to be working, as retail tax preparation is showing growth. It is also worth noting that HRB’s digital offerings are showing growth as well.
Core Market is Growing
The population of the US is growing (more tax filers), and the income tax guidelines are continuing to get more complicated.
The chart below shows the number of words in the Internal Revenue Code and Regulations in thousands.
The population of the US continues to show strong growth.
Oversight of Tax Preparers
The IRS has made statements that it believes paid tax preparers need greater oversight, possibly including such things as licensing and minimum competency tests. While such oversight is likely several years away, it would serve to drive out some of H&R Block’s competitors in the paid preparation field. HRB has said that it backs any such legislation that would increase oversight of the field.
High Insider Ownership
HRB shareholders also benefit from having the interests of management and the company aligned. Chairman of the Board Richard Breeden, through his fund, owns 4.36% of the company.
HRB is currently priced for negative growth on a discounted cash flow basis and trades at only 9 times earnings. With a growing potential market and improving customer service, there is no reason HRB cannot reverse course and see positive growth. Indeed, the company’s interim results have shown signs of growth at their retail locations.
“It is better to be roughly correct than precisely wrong.” -John Maynard Keynes
While it is possible to construct a valuation model based on several different growth rates, I prefer to take Keynes advice. If the market is wrong and HRB does begin to grow, then it is undervalued. By how much depends on just how successful HRB’s efforts are and likely won’t be known for at least another year. HRB is likely worth between $20 and $30 per share depending on how successful the turnaround is. The consensus estimate for earnings this year is $1.44. Attaching a reasonable multiple of 15 gives a price of $21.6 per share, and a higher multiple of 20 would give $28.8 per share.
Disclosure: Long HRB
1 HRB conference calls, Standard & Poors: Reassessing the Cost of the Mortgage Putback Risk for the US Banking Industry