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WIKI ANALYSIS
H&R Block (NYSE: HRB), the dominant store-front tax return preparation company, was estimated by the IRS to have filed 15.7% of total U.S. tax returns in fiscal 2006 (ended April 2006). Yet this enviable standing belies Block's stunted growth over the years and disintegrating market share. The company has not been gaining retail client growth (an important metric in the tax preparation business), unlike its direct competitors Jackson Hewitt, Liberty Tax and especially Intuit's online/software product TurboTax.
As a long term business strategy, Block set out to expand, opening over 1,000 new offices in both FY05 and FY06. However, revenue increases in the fiscal 2007 were mainly a result of higher pricing (6.4% increase to an average net fee of $165) and increased complexity of tax returns, which make for larger fees. Block's US clients grew to 20.3 million, with 19.4% growth in its digital do-it-yourself online/software users and just 0.9% growth in retail users.
Block's unexpected fourth quarter operations for fiscal 2007 were surprising: instead of being a high-profit quarter due to tax return season (the previous year's fourth quarter earnings were US$ 587.5 million), the quarter had a net loss of US$ 85.6 million. For the first time, Block reported an operating loss for the year--a staggering 433.6 million, almost as much as last year's net income of 490.4 million. Block related these expenses connected to complications with its now discontinued subprime mortgage loan business Option One. Block is now divesting itself of the failing company.
Corporate Overview
Founded in 1955, H&R Block and its subsidiaries provide tax return preparation services as well as other financial and business services and products. Tax services are available in the US, Canada, Australia and the United Kingdom. Block's business usually operates at a loss up until tax season, which lasts from January to April, making it a non-cyclical business with the bulk of revenues coming in during the four months of tax season. The year after year returning revenues in the non-cyclical tax services segment is considered a plus for Block.
Tax Services
The tax services and previous mortgage services segments made up just over 75% of revenue (50% and 25% respectively) and 94% of pretax income in fiscal year 2006. The tax services segment derives its revenue from tax return preparation fees and related services/products such as tax return prep courses, sales of software, POM guarantees (see below), online tax preparation help, and electronic filing fees. Tax prep is conducted by professionals in retail offices/franchises or through a number of online do-it-yourself channels. Although Block's TaxCut software product and online-based program is experiencing slight user growth, the program only began to be properly advertised in FY06, and as of now is no match for the massively successful Intuit program Turbo Tax (see Competition below).
The tax preparation market is worth about US$ 19 billion, and includes federal and state tax return fees, electronic filing fees, RAL fees, and other financial product fees. In FY06, 135 million federal tax returns were filed in the U.S.; with the inclusion of state returns, this number is estimated to be around 240 million.
Peace of Mind Guarantee (POM) – is a form of insurance from Block that lets tax clients receive some of the costs associated with errors made on the returns as well as representation for a fee.
Refund Anticipation Loans (RALs) – are loans that may be applied for by eligible clients (up to $9,999) through a designated bank based upon their anticipated federal income tax refund. The bank and Block charge fees for this service, and the loan is repaid as soon as the IRS deposits the refund directly into an account in the lending bank.
Express IRAs – are individual retirement accounts in which clients can grow their retirement savings by investing them in FDIC-insured depository institutions (which pay money market interest rates).
Business Services
Block's RSM McGladrey brand makes up its business services segment. RSM McGladrey is the largest business to focus on the middle market, which represents companies whose revenues are less than 500 million. It is a market with a potential of 13 billion in fees. RSM is the fifth largest US accounting firm, but it does not face much competition from its larger rivals, who tend to focus their energies on larger customers.
Although Block believes this segment has promising potential, RSM suffers from a lack of brand-name recognition (which Block has been building up) and made up only 6% of HRB's operating margin in FYO6.
Consumer Financial Services
H&R Block Financial Advisors
Block has strengthened its financial advisors by replacing underperforming advisors. HRBFA provides advice-based brokerage services and investment planning.
H&R Block Mortgage Corp.
H&R Block Mortgage Corp. originates retail non-prime and prime mortgage loans (75% and 25% respectively). Non-prime loans (unlike prime mortgages) are not offered through government-sponsored loan agencies and are for consumers that may have bad credit, a lot of debt and other problems. These loans are secured by the equity in the properties of these consumers.
H&R Block Bank
The H&R Block Bank recently received its bank charter in May 2006. Block is using its Bank as a key cross-selling strategy. It is hoping to increase retention rates of its consumers generally (currently at 60-70%), and pre-tax season consumers specifically by offering them discounted fees on Refund Anticipation Loans (RAL) once enrolled in the Emerald Master Card debit card program. Initially, the debit card is used to receive anticipated tax refund proceeds, but it may also be used for general banking services. This year, FY07 (ended April 30, 2007), HRB successfully enrolled over 2 million of its RAL consumers into the debit card program.
Also, H&R Block bank is allowing Block to widen its consumer base by providing banking services to an untapped 7 million unbanked clients (Block had over 15 million clients FY06).
Trends and Forces
Lost cross-selling opportunities
In the past Block put a plan in action to take advantage of its financial partnership with its consumers of tax return preparation services and offer them the other financial services it has offered lately. This plan has proved to be somewhat flawed as H&R block mortgage corp. (whose closure was recently announced) and H&R Block financial advisors turned out to be weaknesses in the past and, as of yet, have not realized the cross-selling profits hoped for by Block. The only area that has had better results is the H&R Block Bank.
Option One's selloff
Option One Mortgage Corporation, Block's non-prime mortgage loan business, previously made up Block's mortgage services segment. 75 percent of business in the mortgage services segment came from Option One's "wholesale" non-prime loan originations, which are procured through the help of independent brokers and financial institutions. Non-prime loans are for risky consumers who tend to have bad credit histories and are more likely to default. As a result of heightened competition, a soft housing market and rising interest rates, the once successful sub-prime mortgage lending industry suffered severe losses, even forcing some companies into bankruptcy. Because of decreased profitability, Block announced the sale or spin-off of Option One late 2006.
Block was only able to get a selling agreement in April; it was crucial at the time that Block find a buyer for Option One and at a good price amidst the tales of the diseased subprime mortgage lending industry. As time passed, its opportunities dwindled and possibly Block's stock price with it. Block agreed to sell Option One to Cerberus Capital Management for the net tangible asset value determined at the time of closing, scheduled to be in the second fiscal quarter (ending October). The price amount is estimated to be 300 million minus the 1.27 million net tangible asset value estimated this past January. Also included in the deal is a provision which entitles Block to half of Option One's cumulative income from its loan originations for the 18 months after closing (an amount up to 300 million). This price, although not bad (considering the ailing industrial conditions), is less than the amount the company would have liked to use towards share repurchases. (Share repurchasing and dividend hikes are short-term strategies used by Block to increase stock value in light of slow earnings growth for the company.)
In addition, Block is closing down Option One's wholly-owned subsidiary, HRBMC (part of consumer financial services segment), and leaving the mortgage lending business for good.
Threat from free online filing/digital tax products
Not too many years ago citizens looking to get their tax return filled out knew only one way to do it: they paid to get it done (that is, if they didn’t already do it themselves) and then paid to send it via regular mail. The Free File program, a free online tax return preparation and e-filing service, debuted in 2003 when the Internal Revenue Service (IRS) joined up with a collection of tax software companies called the Free File Alliance LLC. These free digital tax products include Block’s very own TaxAct, Intuit’s TurboTax Freedom Edition, Liberty Tax online and many others. The purpose of the IRS’ creation of the Free File program is to increase the numbers of tax returns filed electronically, allowing for time and cost efficiency.
Ironically, these free tax services point in the way of cannibalization, or the companies’ stealing (usurping) of their own market share. The only thing redeeming them is the low income taxpayers that these free services are restricted to. Most require that taxpayers have an adjusted gross income of 52,000 or less and/or other criteria. Intuit’s free digital tax product is offered to consumers with an adjusted gross income of 28,500 or less or other special criteria.
H&R Block’s own tax reporting dilemma
H&R Block admitted in 2005 to having stated spurious net income results for fiscal years 2003 and 2004. In addition to this, it straight-out claimed that it does not have the resources to accurately report its own taxes, as its transactions are very complex. Block’s restatements were very harmful for a company which depends in large part on a reputation of being tax-savvy. HRB’s restated results for FY03 was previous net income slashed by 102.4 million (to 477.6 million) and a minimal increase of 11.4 million (to 709.2 million) in FY04.
Litigation threats
Block is facing lawsuits stemming from and inherent to its Refund Anticipation Loan program, Peace of Mind guarantee program, electronic filing of tax returns, Express IRAs and others. In these programs Block is mainly accused of fraudulent business practices. Litigation is detrimental to HRB's growth as Block may lose consumers in the wake of such negative publicity related to the lawsuits, on top of the large settlements that Block could be subject to. Block's Provision for litigation settlements in fiscal 2007 was 70.2 million.
Legislative threat to Refund Anticipation Loan
The Refund Anticipation Loan program has been viewed by the US government as "predatory". Instead of terminating RALs, the Federal government is focusing on forcing the cutting down of excessive fees charged in relation with RALs. It is moving to take away the debt indicator, which allows providers of RALs to find out if the consumer owes money to the government, and may not receive their full refund (to pay back the loan). Block has lowered fees recently to comply with this regulation. RAL legislation may prove unfavorable for Block if stricter legislation regulating RALs is passed.
Competition
The tax prep industry is a very competitive one. It consists mainly of two segments: tax preparation done through "paid professionals" and the "do-it-yourself" (DIY) channel. Of the 135 million federal tax returns filed in FY06, 61% were filed by paid professionals and 39% through the DIY channel.
The "paid professionals" segment can be further segmented into "franchised preparation" and "professional preparation" as shown by the graphs. Franchised prep represents Block and competitor Jackson Hewitt (JTX), and professional preparation represents CPA's, small accounting firms and various mom & pop stores. The do-it yourself filers either file manually (or through a friend), or via software provided by the tax prep companies.
Block's market share in all segments of its "for a fee" tax preparation services is 19% compared with only other direct competitor Jackson Hewitt's 4-5% and privately-owned Liberty Tax's estimated 1%. (See operational metrics below). The largest growth opportunity for Block lies in the services provided by CPA's and mom & pop shops (prof. prep.) wherein were filed 63 million returns, or 47% of US Federal returns filed in FY06.
| Market Share | Company-owned offices (US) | Franchised offices (US) | Average Fee per return | |
|---|---|---|---|---|
| H&R Block | 20% | 7,860 | 4,305 | $162.91 |
| Jackson Hewitt | 4-5% | 643 | 5,379 | $177.58 |
Net average fee includes the gross tax preparation and related fees, less coupons and discounts, which is divided by number of clients served.
DIY Channel
In the DIY online/software channel, Block's TaxCut program is far behind primary competitor's Intuit's TurboTax. There isn't an available statistic comparing TaxCut and TurboTax in the online channel, but in the software channel, Taxcut sells about one program for every 4 of TurboTax. The DIY market was 52 million units in FY06, of which TurboTax, TaxCut, TaxAct and other smaller competitors represented 71%. In addition, free online services like Block's own TaxAct steal market share from the paid professionals. The remaining 29% is composed of at-home traditional pen and paper filers, which represent a potential consumer base for Block.
| Units/Returns | Year/Year increase | |
|---|---|---|
| TurboTax | 12.3 million | 19% |
| TaxCut | 3.72 million | 23% |
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