H&R Block Seen Inviting Buyout by Removing Bank: Real M&A

Removing the bank embedded in H&R Block Inc. (HRB) would turn the biggest U.S. tax preparer into a potential takeover target.

H&R Block, which has completed more than 600 million tax returns since 1955, said last week that it hired Goldman Sachs Group Inc. to evaluate options for its six-year-old banking unit amid new Federal Reserve rules requiring savings and loans to hoard more capital. Jettisoning the bank would simplify the business and may boost the odds of a deal, shareholders Yacktman Asset Management LP and Kempner Capital Management Inc. said.

The company is mulling alternatives after a decade-long malaise in its share price. At $17.29, H&R Block trades at a price first reached in 2001 and 43 percent below the record high from 2004. H&R Block’s price-earnings ratio using this year’s estimates is less than 93 percent of U.S. consumer discretionary services companies, and analysts foresee the end to a four-year decline in sales, according to data compiled by Bloomberg. While Schwartz Investment Counsel Inc. said its cash flow generation may lure private-equity buyers, Foxhall Capital Management Inc. said mortgage lenders may see value in combining with H&R Block.

“This company has all the characteristics of a potential takeover target,” Sandy Mehta, Hong Kong-based chief executive officer of Value Investment Principals Ltd., which owns H&R Block shares, said in a telephone interview. Eliminating the bank removes an obstacle that may deter buyers who don’t want the increased regulation such a business brings, he added. “If you get rid of that, that’s one less hurdle.”

‘Too Soon’

Gene King, a spokesman for H&R Block, declined to comment on whether the company is a takeover target.

“Proposed new banking regulations are inconsistent with our strategic plans, operational needs and growth objectives,” King wrote in an e-mail. “Therefore, we have begun to explore alternatives to ownership of H&R Block Bank for delivering financial services and related products to our clients. That process has just begun so it’s too soon to speculate on the timing or ultimate outcome of this strategic review.”

H&R Block, founded in Kansas City, Missouri, by brothers Henry and Richard Bloch, got its start in the 1950s by preparing income-tax returns for individuals. It handled 16 percent of all returns in 2011, according to U.S. Internal Revenue Service data cited in a report by Los Angeles-based industry researcher IBISWorld. In 2006, the company formed H&R Block Bank to offer loans, savings accounts and other products.

Falling Sales

Sales at H&R Block have fallen four straight years, while net income slumped for three, as it fights for tax-return market share versus Intuit Inc. (INTU)’s do-it-yourself TurboTax service. Earnings have also been hurt by the end of refund-anticipation loans, offered to customers as an advance payment of their expected tax refund, amid regulatory pressure and complaints from consumer groups that interest rates were too high.

“For the last few years, revenue growth has generally come in below expectations,” Mike Turner, a Washington-based analyst at Compass Point Research & Trading LLC, said in a phone interview. “They haven’t been able to raise prices much in the last few years.”

The company has been forced to set aside money, reducing net income, in anticipation of losses on loans offered by its shuttered Option One Mortgage Corp. unit. Also, the Securities and Exchange Commission ordered the tax preparer this year to pay more than $28 million to resolve claims it sold investors subprime mortgage-backed securities without disclosing risks.

H&R Block shares peaked at $30.36 in 2004 and have fallen from a 2008 high of $26.50. The decline has left H&R Block trading at 10.7 times analysts’ average projection for the company’s earnings this year, data compiled by Bloomberg show. Only Phoenix-based Apollo Group Inc., the largest U.S. for- profit college chain, has a lower ratio among U.S. consumer discretionary services companies valued at more than $2 billion.

Today, H&R Block shares lost 0.4 percent to $17.23 at 10:15 a.m. New York time.

Takeover Target

Given the low valuation and analysts’ projection for revenue to increase 4.5 percent this fiscal year, which ends in April, H&R Block may turn into a takeover target, Value Investment Principal’s Mehta said. The company’s growth prospects are also bright because of its expansion into overseas markets such as India, he said.

Exiting the bank business would help streamline H&R Block, making it more attractive to potential acquirers, said Shawn Gault, a money manager at Galveston, Texas-based Kempner Capital Management, which oversees about $400 million including H&R Block shares.

“Any time you make a company simpler and eliminate regulations, especially in a banking unit, it could increase the odds” of a deal, Gault said in a phone interview. “It’s a very simple company to understand at that point. It’s simple to understand anyway, so I wouldn’t rule it out.”

Earnings ‘Hiccup’

H&R Block shares dropped 5.4 percent on Oct. 10 after the company said it was considering alternatives for the bank unit. While getting rid of H&R Block Bank may cause a “near-term hiccup” in earnings, the company would also be able to relieve itself of regulatory obligations and could end up saving money, Compass Point’s Turner said.

“They’re not going to have to deal with any Federal Reserve review or any banking review on an annual basis, which probably does provide some cost savings and reduces any kind of potential overhang,” Turner said.

Removing the regulatory requirements that come with bank ownership would make H&R Block a “more attractive takeover target” for private-equity firms that don’t want to deal with such scrutiny, said Tim Schwartz, a Bloomfield Hills, Michigan- based money manager at Schwartz Investment Counsel, which oversees more than $1 billion including H&R Block shares.

Cash Generation

Private-equity buyers could be drawn by “the steadiness of the business, the high free cash generation,” Schwartz said in a phone interview. “That would be a logical choice. That’s who I think is going to take a look.”

H&R Block generated $298.7 million in free cash flow in the last 12 months, almost double the median $158.2 million among similar-sized peers in the U.S. consumer discretionary services industry, according to data compiled by Bloomberg. The company had $1 billion in total debt and $939.9 million in cash as of July 31, the data show.

Financial institutions including mortgage lenders may be tempted by H&R Block and its almost 11,000 retail locations across the country, said Paul Dietrich, CEO and co-chief investment officer of Middleburg, Virginia-based Foxhall Capital Management, which oversees more than $100 million including H&R Block shares.

“This would be an attractive place for people because they have a distribution system that’s already in place,” Dietrich said in a phone interview.

Disappointing Offer

While Schwartz estimates H&R Block could fetch between $20 and $25 a share in a takeover, Value Investment Principal’s Mehta said the company could attract bids of $30, a 74 percent premium. That might undervalue the company and may not be the best option for shareholders, Mehta said.

“I actually would hope that it doesn’t get taken over in the near term,” Mehta said. “I would like it to be taken over two or three years from now when the stock is already at $25 and then somebody puts a bid on the table, rather than somebody try to steal it too cheaply.”

Still, H&R Block might be forced to sell at a low valuation if concerns about its business persist, Foxhall’s Dietrich said.

A divestiture of the bank business “is going to make it a takeover target,” Dietrich said. “That’s probably not what H&R Block wants” and “they’re not going to get quite the price that I think the H&R Block board thinks that it’s worth.”

Whittling H&R Block’s business down to tax preparation helps make the company more attractive as a takeover candidate, said Donald Yacktman, president and co-chief investment officer at Austin, Texas-based Yacktman Asset Management, which oversees about $20 billion including H&R Block shares.

Getting rid of banking “makes it nice and clean,” he said in a phone interview. “Then it becomes a function of price.”

To contact the reporter on this story: Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story: Sarah Rabil at srabil@bloomberg.net

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