H&R Block: One Tax Story You Just Might Like

A compelling valuation with a big upside.

May 20, 2014 at 7:00AM

H&R Block (NYSE:HRB) was founded in 1955 as a brick and mortar tax preparation company. After expanding into a large number of other financial services, in recent years H&R Block has started to rationalize its portfolio of services, focusing primarily on tax preparation. H&R Block has 12,000 offices worldwide with the majority, over 10,000, located in the United States. In 2013 the company prepared over 24 million tax returns through its owned, franchise and digital solutions. While late to the digital opportunity, after ceding share to its competitor Intuit for a number of years, in recent years H&R Block has invested heavily in its digital presence and grown its market share (though still severely lagging Intuit Turbo Tax). 

As part of its portfolio rationalization H&R Block announced on April 10th the sale of H&R bank (chartered in 2006 to provide additional financial services) to BOFI. The original idea of H&R Bank was to leverage the relationship that the company had with customers through its tax business to offer additional financial services. Unfortunately this less successful than planned and ultimately led to the sale of the bank in order for the company to focus on its core tax preparation business. 

The divestiture is significant because it allows the company to pursue a more aggressive capital allocation policy. Banks are regulated by the government and must meet certain capital and funding metrics. H&R Block stand-alone would not be constrained by these regulations. Post-closing the deal H&R Block will most likely recapitalize its balance sheet to > 3x EBITDA / net debt and announce a large buyback. Over the next 3 years H&R Block will be able to buy back over 30% of its shares outstanding with existing free cash flow (excluding dividends) and excess cash (post recapitalization). 

Assisted Tax Preparation ... still a growth opportunity
Today H&R Block has the largest share of the assisted tax preparation (non-DIY) market in the United States, holding close to 20% market share. This market has been relatively slow growth from 79M in 2010 to 80M in 2013. However, the recent enactment of Obamacare will significantly increase tax complexity for not only the 45M uninsured, but those who could potentially garner savings through the Advance Tax Credit. H&R Block has already created a service directly targeting this segment known as H&R Block Tax and Health Review (http://www.hrblock.com/health care/tax-health-care-review.html). The assisted tax preparation market should see a reacceleration of growth to a conservative 5%+ CAGR over the next few years. 

Another potential upside in 2015 is congress and Obama passing legislation to regulate tax preparers. The IRS has recently been fighting with the federal courts to allow them to regulate what they believe is a large number of unscrupulous tax preparers. With the added complexity of Obamacare it is likely that Congress and Obama will push to enact legislation allowing the IRS this power. This would significantly open up H&R Block's opportunity to capture the more than 50%+ share of the 80M assisted tax preparation category that is done by independent tax preparers. 

Valuation
H&R Block is currently trading at 12x FY2016 (year ending April, so a closer approximation of calendar 2015) sell-side expectations. Including share buybacks, the introduction of Obamacare, share gains within the assisted tax preparation market, and operating leverage, H&R Block could do over $3.25 of EPS in FY2016. Applying a current market multiple to the stock would yield a $39 price. This is on top of the 3% dividend yield (or $0.80 per year) that a shareholder of the stock would receive. Altogether H&R Block offers an investor over 50% upside with more if it is rewarded with multiple expansion due to a reacceleration of growth in the market.

This article originally appeared on Value Penguin.

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