New Tacks for H&R Block

H&R Block (HRB ) is slowly achieving its goal of becoming a one-stop resource for financial services. The strategy is to offer something for everyone, while also targeting higher-income customers with new products and services. Judging by the stock's recent run-up, shareholders like what they see.

The company, best known for its tax-preparation services, now offers brokerage, mortgage, and other financial services, which it has begun cross-selling to its taxpaying customers. The company has opened 180 H&R Block Financial Centers, offering one-stop shopping. The company plans to open more of these offices in 2002, but isn't offering any specifics yet.

So far, the strategy appears to be working. On June 20, the company reported fiscal 2001 (ending Apr. 30) earnings of a record $281.2 million, or $3.04 per share, VS. the $251.9 million, or $2.55 reported for the prior year. Revenues for the period increased 22.4% to $3 billion. H&R Block also announced a 2-for-1 split of its common stock effective Aug. 1, and a 7% increase in the quarterly cash dividend, to 16 cents per share (split-adjusted), payable Oct. 1.

"BREAD AND BUTTER."  The bulk of the company's revenue still comes from its cash-cow tax-preparation services. Of the $3 billion in 2001 revenues, $1.7 billion was generated by its U.S. tax services. The company has a 47% market share among taxpayers who use a service to prepare their return. H&R Block serviced 19.2 million taxpayers in 2001 -- roughly one out of every seven returns filed with the IRS.

International tax preparations tacked on an additional $79.6 million in revenues. Mortgage operations contributed $415.8 million, and revenues from investment services totaled $472.4 million. Business services added $373.8 million. "The low- and middle-income American taxpayer will always be the bread and butter," says Matthew Litfin, who covers the company for William Blair & Co.

So why diversify? According to Litfin, the average fee per U.S. tax client was $111.51 as of the end of the 2000 tax season, representing a three-year compound annual growth rate of 9.7%. "The fact...is the tax business is going to [generate revenue growth in] the mid to high single digits going forward," says Alexander Paris Jr., an analyst at Barrington Research Associates.

Building upon its tax-preparation services appears to be a good call, though the results haven't been dramatic so far. Litfin says this ballgame is "only in its second or third inning." But H&R Block has a leg up on most competitors. The information within a tax return is very valuable from a marketing perspective. For example, it shows whether the individual owns or rents, whether he or she has dependents, and whether there is an IRA. Congress allows tax information to be used only for preparing returns unless the individual filing signs a waiver, so H&R Block has stepped up efforts to get clients to sign such waivers.

MULTIPLE SERVICES.  The company says it still can't track the rate at which tax-preparation customers are using the company's other services. But H&R Block CEO Mark Ernst points out that nearly 30% of its retail mortgage originations came from tax clients. The exec added that during the past tax season, approximately 40,000 H&R Block clients also become investment clients. H&R Block has roughly 600,000 brokerage accounts.

Another key piece of the company's strategy is to attract higher-income individuals. The higher the income, chances are the more complicated (and costly) the tax preparation will be. The company also targets higher-income clients through its RSM McGladrey Inc. division, an accounting, tax, and consulting practice that focuses on mid-size businesses.

Of course, there's no understating the impact of the tax cut. It has several phase-ins in the next decade, with new rules and stipulations each year, which will make tax preparation ever more complicated. Analysts and company executives believe the average confused taxpayer will gravitate to H&R Block to make sure they get every penny of their tax returns. Ernst estimates the new tax law could "easily" lead to client growth of 2 percentage points.

"VALIDATION."  Investors appear confident about the evolving business model. The company's shares, which began the year at around $41, now trade at around $63 a share. The biggest bump-up came on Feb. 14, when Warren Buffett's Berkshire Hathaway (BRK.B ) acquired 7.7 million shares, sparking a 43% jump. Berkshire Hathaway now holds a 8.4% stake in the firm -- something Ernst likes to crow about. "It's not changing what we're doing, it's more a validation of the strategy that we've been pursuing," he says.

One investor concern could be that the company historically generates virtually all its profits in its fiscal fourth quarter, which covers the February-April tax preparation season, with the prior three quarters usually resulting in net losses. That's a smaller window for generating black ink than most large companies have. In past years, H&R Block would shut down many of its offices after the tax season to stem those losses. Now that it's diversifying its products and services, it no longer has that option. But Ernst says the seasonal nature of part of his business isn't a concern.

OLDE TROUBLES.  A sour market has put a damper on the company's brokerage operations, marring an otherwise solid balance sheet. H&R Block acquired its discount brokerage, formerly known as Olde Financial Corp., in 1999, well before the market went south. This year, pretax earnings from H&R Block's investment services declined 69.2% year-over-year to $12.7 million. However, $17 million of the loss was related to litigation brought against Olde prior to the H&R Block acquisition. There was also a $1.6 million one-time charge related to staff reductions at Olde.

"We're clearly being affected, much like the rest of the industry, [by] the slowdown that's occurring," says Ernst. "Our own internal planning has assumed that it's going to be a difficult year through the balance of 2001."

Litfin, who's carrying a buy rating on H&R Block shares, sees a bright long-term horizon. "You'll see H&R Block transforming itself into more than the leading tax-preparation company," he says, calling the company the "average Joe's Merrill Lynch." And as a mid-cap growth stock trading at some 19 times earnings per share estimates for fiscal 2002 and 13% EPS growth, H&R Block shares are still looking pretty attractive.