Skip to Content
Stock Strategist

Industry Changes Affect H&R Block

H&R Block faces three major headwinds.

Mentioned: , ,

 H&R Block's (HRB) stock has fallen approximately 50% since the beginning of the year, and this has created what may seem like a good buying opportunity. However, we believe investors should be cautious given the current uncertainty surrounding the name. H&R Block faces three major headwinds, and the clouds surrounding the tax industry veteran have been slow to abate. Given the confluence of these factors, we would advise investors to approach the stock with a healthy dose of skepticism.

Losses from Subprime Mortgages
In 1997 H&R Block acquired Option One Mortgage in order to seek growth and profit expansion. During the housing and mortgage boom, the firm sought to increase revenue and profit through underwriting and selling subprime mortgages. As the housing crisis worsened, the value of the firm's mortgage book fell and it sustained heavy loses. Not only did this strategic misstep cost H&R Block greatly, it distracted management from the firm's core operations, in our opinion.

Apart from these initial issues, there is now some concern that investors who are currently sustaining loses from mortgages H&R Block sold a few years ago could demand the firm cover these loses. Thus, there is a major overhang and expectation that H&R Block will have to take on these losses. We believe this headwind is somewhat overdone; however, the probability H&R Block will need to cover some of these mortgage-related loses is material, in our opinion.

Inability to Provide Refund Anticipation Loan
H&R Block's only funding partner for its highly profitable refund anticipation loan (RAL) product,  HSBC (HBC), has refused to honor its contract and provide funding for the 2011 tax season. H&R Block has sued HSBC to try and force it to provide funding, but there is a significant probability the firm will not be able to offer these products. This would have a major effect upon the firm's earnings as these products contribute approximately 10%-11% to operating profit.

At the heart of the problem are two issues:

  1. The headline risk associated with these products may be to much for HSBC, as consumer advocacy groups view these loans as predatory. Additionally, the federal government has signaled it also believes this to be the case and has pressured the financial services industry to stop providing funding for RAL products.
  2. The IRS has recently stated that it will no longer provide something called a debt indicator to tax return processors and their financial institution partners. The debt indicator used to flag if a tax payer owed any back taxes or other garnishments that would be withheld from their refund. This was a key variable H&R Block and HSBC used to decide who was creditworthy enough to receive a RAL product. With the debt indicator no longer being provided, HSBC may now believe the credit risk associated with these products is not worth the return.

These factors have motivated many financial institutions to halt and refrain from providing funding for these products. We have believed these products would eventually disappear over the long term; however, the pace has sped up dramatically.

The DIY Network
We have concerns that do-it-yourself (DIY) services will most likely cause a disintermediation for H&R Block's core brick and mortar services over the long term. DIY services have been growing in acceptance among the retail tax preparation customer base, and the advent of these services has changed the competitive dynamics within the retail tax preparation market. These services are priced significantly lower than traditional branch tax services, and the value proposition is very compelling to consumers. We believe that DIY products have also demystified the tax preparation process, creating even greater pricing sensitivity among U.S. taxpayers. This migration has been highly beneficial to the DIY leader  Intuit (INTU), which we now estimate has become the market leader after the 2010 tax season.

Concluding Thoughts
Even though H&R Block faces some steep obstacles, we believe its business will not disappear. There will always be retail tax customers who will seek assistance in preparing their returns. Additionally, the issues of mortgage putbacks and RAL products create meaningful near-term uncertainty but will dissipate over the long term. However, the long-term migration of customers toward DIY products will continue and this will mean lower pricing and greater competition for the industry, in our opinion.

Vishnu Lekraj does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.