Monday, August 27, 2012

H & R Block, Great Yield But Where is the Growth?

H & R Block (NYSE: HRB) offers a classic value proposition for value investors. The company generates large amounts of cash flow and is actively engaging in restructuring efforts, all of which will continue to enable the distribution of cash returns to investors. Ultimately if looked at as a company capable of generating GDP type returns, it looks attractive compared to say a US Treasury.
However, the real question is what level of confidence investors can have growth prospects and the sustainability of its market positioning?


Intuit’s Strength Has Forced Change at H & R Block

The tax preparation market has been evolving in recent years and Intuit (NASDAQ: INTU) has been aggressive in migrating its software offering into a cloud based solution. In fact the company is the poster child of businesses that have successfully leveraged into the cloud.

The consequences for H & R Block have been significant. It has been forced into expanding in its own digital business and found itself having to scale back store expansion plans. Ongoing rationalization plans have reduced the cost base and the shedding of non-core business has increased focus on the most profitable parts of the company. The cost savings alone are forecast to add $85-100m to pre tax earnings in 2013. Whilst asset sales (mainly tax stores) have brought one-off benefits, they are set to slow in future as the larger part of sales have already taken place.

In addition, it has stepped up marketing and promotional activity in an effort to defend its market share. Marketing spend went up 15% last year in order to defend its competitive position and promote its online and digital offerings.  Promotional activity was focussed on the free offering of Refund Anticipation Checks (RAC) which led to a $49m decline in revenues.  The plan is to discontinue this promotion in the coming year, but given the ‘new frugality’ in consumer behaviour I suspect this will be met with a significant amount of consumer resistance.

So H & R Block is doing the right things but what is happening to its core business?


Core Revenues Challenged

The core tax services revenue division reported a 1.7% decline but this was largely due to a drop in financial product revenues. In contrast, tax preparation revenues increased but only marrginally. Meanwhile, its digital revenues increased 11% which is ahead of the 8% that it forecast the overall digital market increased by.  However, as previously noted H & R Block increased marketing expenses by 15% so this growth did not come without a cost.

The extra marketing expense clearly worked because management claimed it had expanded market share online and in its software offering. Moreover, it feels that digital growth is moderating and Intuit has been reporting weaker than expected growth in its TurboTax product.

The big hope for H & R Block is that with Intuit trying to secure growth by offering more advice to the client, the market conditions appear to be evolving in its favour. I’m not sure that this is necessarily the case for the long term. Employment gains have been weaker than most expected this year, so growth moderation in digital tax preparation is to be expected and it’s not surprising to see the likes of Intuit trying to offer more value added advise. However, the trend towards digital appears to be an inexorable one and it’s hard to have much confidence that H & R Block’s previous model will come back into style.

Indeed, future threats could emerge from companies like the UK’s Sage or Microsoft (NASDAQ: MSFT) could start bundling tax preparation software with other software in order to create a suite of products to the SMB and consumer sectors. Analysts have expected this sort of thing from Microsoft for years but perhaps this is the right time?


Emerging Market Growth?

One area where H & R Block can offer growth is in international expansion and in particular India is being cited as an expansion opportunity. Thus far it is a small part of revenues with only 3.2m tax preparation returns – of the 25.6m total- coming from international markets. With a lot of those returns coming from mature markets like Australia and Canada, it is hard to see international revenues having a meaningful impact in the near future.

Talk of Indian expansion is exciting enough, and there may well be huge numbers of taxpayers there, but the company has only opened three offices in India. Revenues and profitability were described as being ‘not material’ and management see it as a 10-20 year play. Frankly, I wouldn’t get too excited about emerging markets as being a near term profit driver for H & R Block.


Where Next For H & R Block?

The core business is surely challenged on a structural basis but restructuring and international expansion offer hope of future profits growth. In addition, asset sales and distributions to shareholders (not least via a 5% dividend yield) offer some underlying support to shareholders. The stock won’t be attractive to more growth orientated investors as it’s hard to see where it can generate significant top-line revenue growth. International expansion is more of a long term story and local challenges remain. For yield chasers only.