Do You Trust the Earnings at H&R Block?

Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measure of a company's economic output. That's because earnings are very often less trustworthy than cash flow, since earnings are more open to manipulation based on dubious judgment calls.

Earnings' unreliability is one of the reasons Foolish investors often flip straight past the income statement to check the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the last batch of earnings brought money into the company, or merely disguised a cash gusher with a pretty headline.

Calling all cash flows                                                                             
When you are trying to buy the market's best stocks, it's worth checking up on your companies' free cash flow (FCF) once a quarter or so, to see whether it bears any relationship to the net income in the headlines. That brings us to H&R Block (NYSE: HRB  ) , whose recent revenue and earnings are plotted below.

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. Dollar values in millions. FCF = free cash flow. FY = fiscal year. TTM = trailing 12 months.

Over the past 12 months, H&R Block generated $707.4 million cash on net income of $501.7 million. That means it turned 18.3% of its revenue into FCF. That sounds pretty impressive. Still, it always pays to compare that figure to sector and industry peers and competitors, to see how your company stacks up.

Company

TTM Revenue

TTM FCF

TTM FCF Margin

 H&R Block $3,870 $707 18.3%
 Paychex (Nasdaq: PAYX  ) $2,019 $551 27.3%
 Intuit (Nasdaq: INTU  ) $3,513 $834 23.7%
 CBIZ (NYSE: CBZ  ) $730 $52 7.2%

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. Dollar values in millions. FCF = free cash flow. TTM = trailing 12 months.

All cash is not equal
Unfortunately, the cash flow statement isn't immune from nonsense, either. That's why it pays to take a close look at the components of cash flow from operations, to make sure that the cash comes from high-quality sources. They need to be real and replicable in the upcoming quarters, rather than being offset by continual cash outflows that don't appear on the income statement (such as major capital expenditures).

For instance, cash flow based on cash net income and adjustments for non-cash income-statement expenses (like depreciation) is generally favorable. An increase in cash flow based on stiffing your suppliers (by increasing accounts payable) or shortchanging Uncle Sam on taxes will come back to bite investors later. The same goes for decreasing accounts receivable; this is good to see, but it's ordinary in recessionary times, and you can only increase collections so much.

So how does the cash flow at H&R Block look? Take a peek at the chart below, which flags questionable cash flow sources with a red bar.

Source: Capital IQ, a division of Standard & Poor's. Data is current as of last fully reported fiscal quarter. Dollar values in millions. TTM = trailing 12 months.

When I say "questionable cash flow sources," I mean items such as changes in taxes payable, tax benefits from stock options, and asset sales, among others. That's not to say that companies booking these as sources of cash flow are weak, or are engaging in any sort of wrongdoing, or that everything that comes up questionable in my graph is automatically bad news. But whenever a company is getting more than, say, 10% of its cash from operations from these dubious sources, investors ought to make sure to refer to the filings and dig in.

With 69.9% of operating cash flow coming from questionable sources, H&R Block investors should take a closer look at the underlying numbers. Within the questionable cash flow figure plotted in the TTM period above, other operating activities (which can include deferred income taxes, pension charges, and other one-off items) provided the biggest boost, at 46.8% of cash flow from operations. Overall, the biggest drag on FCF came from capital expenditures, which consumed 14.3% of cash from operations.

A Foolish final thought
Most investors don't keep tabs on their companies' cash flow. I think that's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home-run stocks that provide the market's best returns.

We can help you keep tabs on your companies with My Watchlist, our free, personalized stock tracking service.

Seth Jayson owned shares of the following at the time of publication: Paychex. You can view his stock holdings here. He is co-advisor of Motley Fool Hidden Gems, which provides new small-cap ideas every month, backed by a real-money portfolio. Paychex is a Motley Fool Inside Value selection. Motley Fool Options has recommended a write covered straddle position on Paychex. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (0)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 09, 2010, at 10:43 PM, FrankDip wrote:

    HRB rents 10,000 strip mall offices twelve months every year. They use them , for the most part, for 4 months. They also are trapped into defending their brick & morter business when online tax returns are the fastest growing segment of the market.

    HRB refuses to migrate to online as it will destroy the stores.

    In addition 45% of their business is associated with RALs (Refund Anticipation Loans) thru HSBC bank. HSBC says they will no longer offer the product. Without RALs HRB will lose the most profitable portion of their business as HRB charges clients based on the complexity of the tax return as defined by the tax forms utilized for the tax return. Most clients who get RALs are using the Earned Income Tax Credit form which is a Refundable Credit - meaning you get it even if you have no tax liability. HRB charges a lot of money when this form is used as they essentilaly are getting paid from the clients EITC proceeds.

    Business will crater wityhout RALs.

    Bottom line - do not buy this stock regardless of what Scaramuchi says on CNBC.

  • Report this Comment On January 17, 2011, at 12:25 PM, angelhrb wrote:

    H&R Block has many company offices that are not all in strip malls. H&R Block is open all year round at designated offices. Every client has the ability to get a hold of an office during the off season.

    H&R Block is not trapped due to the fact we have many opportunities. H&R Block also has invested into TaxCut along with the online program are clients are even able to go to the H&R Block website and even file there return for free.

    H&R Block's business is not made up RAL's. HSBC and H&R Block had come to a agreement on December 21, 2010 when the OCC stated that HSBC could no longer do RAL's even though there had been an agreement with H&R Block.

    I have worked for H&R Block for 12 years and this information you are putting out is fraudulent.

    I would be more than glad to put my money into this stock. It would be more frightening to see Jackson Hewitt and Liberty tax service since they do not have a national bank to look into they are using local banks to fund their products. They will probably run out of money before the middle of tax season and then where will they be.

    H&R Block has their own bank and will be able to take care of their own clients.

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