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H&R Block: The Worst Stock in the S&P 500

"Flabbergasted" would be the best word to describe my reaction to a late-night commercial stating that H&R Block (NYSE: HRB  ) would offer free federal filings, in-store, through Feb. 15.

How desperate has H&R Block become, if it needs to resort to coaxing taxpayers into its stores with free federal filing? I mean, I've seen free federal filings being touted for digital tax software -- like TurboTax from competitor Intuit (Nasdaq: INTU  ) -- for years now. But never has a behemoth like H&R Block offered to tie up its in-store employees with free federal filing.

Sure, it might seem unfair to pick on poor H&R Block while it's down, since it was the second-worst-performing S&P 500 company in 2010. But there are simply too many negatives here to see any sunshine on the horizon.

Therefore, H&R Block, I crown you the worst stock in the S&P 500!

Late to the game
Americans have drastically changed the way they complete their taxes over the last decade. Taking care of your finances by personal computer has become the preferred method for most Americans. But H&R Block has seemingly had blinders on, adapting at a snail's pace.

It does have H&R Block At Home, and it recently entered into an agreement to purchase 2SS's digital tax software TaxAct, but its taking its sweet time making the transition. This has allowed Intuit to exploit America's stay-at-home, do-it-yourself attitude to the tune of 20 million TurboTax unit sales last year alone. As Eastman Kodak is to photography, H&R Block is to financial services -- always lagging behind the innovation curve.

Refund rejection
Having Intuit run circles around you is bad; getting the shaft from the IRS and the Office of the Comptroller of the Currency (OCC) is even worse.

In August, the IRS stopped reporting its debt indicator -- a measure of unpaid dues and delinquent student loans -- to financial institutions and tax preparers. Without this indicator, the repayment risk of H&R Block's highest-margin product, the Refund Anticipation Loan (RAL), jumped dramatically.

RAL's are short-term credit loans secured by a taxpayer's pending refund. In its latest quarterly filing, H&R Block reported that roughly 21% of its revenue comes from RALs. Now, fast-forward to Dec. 27, 2010, when the OCC directed HSBC, H&R Block's main lender, to cease providing RALs. This leaves the company high and dry, with no lender to provide it sufficient liquidity to issue RAL's in the upcoming tax season. H&R Block's only countermove is to issue its Emerald Card prepaid credit card. That's a start, but it hardly puts a dent into the loss of a high-margin and significant chunk of its business.

Who will reap the rewards of H&R Block's downfall? How about the unlikely Jackson Hewitt (NYSE: JTX  ) , the nation's second-largest tax-preparation service? Just one month ago, Jackson Hewitt secured a pact to extend lending 80% of its RALs through Republic Bancorp (Nasdaq: RBCAA  ) . I'd suspect that most low-to-middle income customers who are anticipating a refund, and prefer to use a RAL to get that refund more quickly, will opt to head to Jackson Hewitt instead of H&R Block.

Mortgage meltdown
H&R Block's precarious downfall began in 2007 with the poor quality of its mortgage loan portfolio. H&R Block ceased originating mortgages in 2007, but falling housing prices and potential mortgage putbacks continue to dampen its near-term outlook.

In short, if certain conditions are met, and the originator of the loan -- in this case, subsidiary Sand Canyon -- proves to have been deceptive in its loan practices, H&R Block could be required to repurchase the loan. These putbacks can't bankrupt H&R Block -- at most, they could only drain the entire value of Sand Canyon alone -- but they remain a nagging problem for the former lender.

Based on recent figures, these putbacks are doing progressively less damage with each quarter. The amount H&R Block needs to set aside to counter these loans has fallen in recent months, but the company's hardly out of the woods yet. The total quality of H&R Block's remaining loans is still poor, and they remain a stinging reminder of the company's future liability.

The nail in the coffin comes from H&R Block's erratic financial performance. Fellow Fool Seth Jayson has done the homework for us, and the numbers show that 70% of H&R Block's operating cash flow comes from questionable, potentially non-recurring sources. Combined with the loss of RALs, that could force the company to cut its dividend. What looks like a tempting 4.7% yield today could ultimately be just smoke and mirrors.

H&R Block had a terrible 2010, and nothing thus far signals that it will be any better this year. This has all the makings of a money pit. Do yourself a favor and kick this stock to the curb.

Fool contributor Sean Williams does not own shares in any companies mentioned in this article. He is an admitted TurboTax addict. You can follow him on CAPS under the screen name TMFUltraLong. 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 (16)

Comments from our Foolish Readers

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 January 11, 2011, at 4:47 PM, virginialt wrote:

    Don't short change Liberty Tax Service. They will pick up a lot of HRBs customers, too!

  • Report this Comment On February 21, 2011, at 11:21 AM, seriously11 wrote:

    Doing taxes for free may not be the financial drain you suggest. The tax preparers are getting zero pay for doing these returns. Traditionally they are paid hourly wages but given a bonus at the end of the season based on paid returns. Since these are counted in there, the bonus will be nonexistent or very low for most preparers in 2011. So the company is not out that much money, since it already has the locations, equipment and software and now labor is virtually free. I'd say the stock isn't as bad a deal for investors as employment with HRB is for preparers this year.

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