Obviously 2020 has not been kind to shareholders of H&R Block (HRB) so far, with shares down about 45% since the beginning of January. When shares fall this far this fast, I obviously become interested, so I thought I’d review the name to see if it makes sense to buy or sell at these levels. For those who missed the title of this article, and who can stand neither the suspense nor my writing, I’d say that shares now represent great value. While I think buybacks have been a waste for this company as with so many others, management has been quite shareholder friendly in my estimation. I consider this to be a necessary precondition to investing, because an unfriendly management virtually guarantees a loss. In addition, I think the company has sufficient cash on hand to weather the current storm, and I think the dividend is reasonably safe. Most compelling of all, in my view, is the fact that the shares haven’t traded at these levels for many years, and last time they traded at this valuation, they went on to do very well. For those who are still nervous about buying shares, I recommend a short put trade that I think offers investors a “win-win.” I’ll go through my arguments in greater detail below.
There is a Canadian billionaire investor named Stephen Jarislowsky that I met years ago, and we talked for about 3 hours about investing, history, and the Anglo-Francophone relations in his home province of Quebec. I think one of his observations about the company Alcan can be applied to H&R Block. “It’s like a cork bobbing in the ocean…it’s got little direction, but you can’t sink it.” There’s been little growth from H&R Block over the past several years, but I think the dividends are secure in light of the fact that the payout ratio remains consistently around 50%. It seems that some investors have been premature in calling for the death of H&R Block in the teeth of the DIY tax providers. I think this is a great investment for people who are interested in buying a relatively secure, boring, cash cow. In my estimation, “boring” is ideal, especially now that the dividend yield has breached 8%.
Digging into the financial history here reveals some interesting findings. I know. It’s odd to find financial history interesting. I have issues, obviously. Moving focus away from my various eccentricities, sales have grown very slowly at this firm for years. Specifically, H&R Block has managed to improve revenue at a CAGR of about .38% over the past six years. Unfortunately, net income has fallen at a CAGR of about 2% over the same period. That hasn’t stopped dividends per share and earnings per share growing at CAGRs of 2.9%, and 3.8% respectively. This improvement in earnings per share in the face of dropping net income is obviously a function of a share buyback program, about which more below. The $2.766 billion buyback program is one of the ways in which management has returned capital to owners over the past seven years. They have also returned just under $1.39 billion to shareholders in dividends since 2014.
Turning to the capital structure, it appears that cash on the balance sheet has deteriorated markedly since I last looked in on the name. This is relatively normal, given the seasonality of this business. For example, at the same time last year, cash was just over $203 million, and three months later it had climbed to $1.572 billion. For that reason, I think drawing conclusions about the health of the balance sheet from its current state would be naive. In addition, in spite of the fact that long term debt has grown at a CAGR of about 11% over the past 6 ¾ years, interest expense has been falling fairly dramatically over the past three years. This is obviously a function of lower lending costs. For my part, I’d like to see management reduce long term debt, obviously, but I don’t think there’s much risk of a credit or solvency crisis here anytime soon.
I think the most recent nine months relative to the same period a year ago has been quite good in my estimation. Specifically, revenue and net income were up by 8.9% and 2.75% respectively, suggesting that worries about the imminent death of H&R Block are slightly exaggerated. Earnings per share have grown by just under 7%, and dividends are up by 4%.
The Problem With Buybacks
For me, the current market downturn has put a highlight on share buybacks. This is a problem with most companies I cover, but I’ll pick on H&R Block as an example in order to make the broader point. When I was back in business school in the late 19th century, I was introduced to the idea that investors should be indifferent between receiving a dividend or having management plow the returns back into the company. I’ve also heard frequently that a share buyback is the same as a dividend. I disagree with this notion, and I’d like to use H&R Block as an example. Over the past 6 ¾ years, management has spent just over $2.76 billion on stock buybacks and reduced the shares outstanding by 81,753. This means that management bought these shares back at an average price of $33.84 per share. Had management left the number of shares constant, they could have returned this to shareholders and they could have consumed it. Six years ago, shares were trading at approximately $30, and they currently trade for just under $13. Had investors received the money that management spent on share buybacks, they would have received just over $10 in dividends. This, plus the dividends they’ve received over the past 6 ¾ years, would have meant that investors were closer to a breakeven than they currently are.
In addition, there’s something paternalistic about share buybacks, because it implies that management knows better than investors about how to spend their capital. Investors are owners of the enterprise, and therefore it should be run for their benefit. To deprive investors of the freedom to decide how to spend their profits is troublesome, and I think management should stop the practice immediately.
Source: Company filings
I’ve said on at least a few occasions that there’s a disconnect between underlying businesses and the stock that supposedly represents the fortunes of that business. In my estimation, stocks are actually very poor proxies for the health of the underlying enterprise, and the past few weeks have demonstrated that fact. In my view, investors have the opportunity to exploit the disconnect between the enterprise and the stock that supposedly represents that enterprise. I think price and value can remain unmoored for some time, but will inevitably meet at some future point. This means that investors can buy stocks when they are out of favor and ride them higher, or sell stocks that are very popular but overpriced.
With that out of the way as a prelude, I want to try to work out whether the shares of H&R Block currently represent good value or not. In other words, I want to answer whether shares will eventually rise to match value. I make this determination in a host of ways, from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value like earnings, free cash flow and the like. I want the stock in question to trade at a discount to the overall market and to its own history. At the moment, I’d say shares of H&R Block meets these criteria, given that they’re trade at a discount to the overall market and to their own history, per the following. While I don’t believe history repeats, it certainly rhymes. I’d note that it’s been about a decade since the shares were this inexpensive, and they subsequently went on to do very well over the next five years. H&R Block stock adds weight to the claim that the lower the price an investor pays for a stock, the greater will be their subsequent returns.
In addition to a simple ratio of price to economic value, I want to try to understand the assumptions embedded in the current price, and what that says about the market’s expectations about future growth. In order to do this, I turn to the methodology described by Professor Stephen Penman in his book “Accounting for Value.” In this book, Penman describes how an investor can use a standard finance formula, and isolate the “g” (growth) variable to work out what the market must be assuming about the company’s future. Applying this to H&R Block suggests that the market is assuming the company will be bankrupt over the next 10 years. In my view, this is an excessively pessimistic forecast, and I like to find very pessimistic forecasts.
Options for the Nervous
In my view, now is a good time to buy H&R Block, but I can fully understand why an investor might have been a bit traumatized by market behavior over the past few weeks. For such people, I would recommend selling put options at strike prices that represent excellent value. I think such a trade represents a “win-win”, because investors either pocket premia if the stock remains above the strike price, or the investor buys what I consider to be a great business at an even more attractive price.
At the moment, my preferred short put is the October 2020 with a strike of $10. These are currently bid-asked at $.90-$1.50. If the shares find support at current depressed levels, the seller of these puts simply pockets the premium. If the investor sells at the bid and the shares continue to fall, the investor will be obliged to buy at a net price about 29% below the current level. Ceteris paribus, that represents a forward PE of ~4.5 times, and a dividend yield of about 11%. Note that these shares didn’t reach that level during the slough of despond in 2008, and haven’t changed hands at $10 since January of 2001.
I think there’s much to like about H&R Block. I dislike that it appears that management has overpaid for shares over the past six years, but H&R Block is hardly unique in this regard. The company has managed to grow revenues slightly over the past 6 ¾ years in spite of the encroachment of DIY tax solutions. In my experience, the market has assumed (wrongly) that H&R Block will go the route of Blockbuster because everyone will suddenly start doing their own taxes. In my estimation, doing taxes is an annual trauma akin to root canal. I think there’ll always be customers willing to pay to offload the painishment of taxes to a professional. More compelling than the state of the business is the fact that the shares are trading for multi-year lows. The last time they traded at these levels, they went on to do very well over the next five years. For those who want an added advantage, I think short put options present a “win-win” trade at this point. As I wrote earlier, I think price and value can remain un-moored for some time, but at some point they will meet. I think investors would be wise to buy the shares and/or sell the put options mentioned above.
Disclosure: I am/we are long HRB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In addition to buying more shares, I’ll be selling the puts mentioned in this article.