Betting on Bigger Returns for H&R Block

The CEO says results from his expansion will take a while, but they'll be worth the wait

Taxes may be one of life's two certainties, but that's not sure enough for H&R Block Inc. (HRB ) CEO Mark A. Ernst. Ever since the 43-year-old joined the No. 1 U.S. tax preparer in 1998, he has been hell-bent on diversifying into other financial services. He is undeterred by the failure of his predecessors' moves into legal services or the ill-timed sale of Internet service provider CompuServe Corp. for $1.3 billion in 1998 when critics said it was worth twice that.

Yet Ernst, a former American Express Co. executive hired from outside the Bloch family to run the 47-year-old company, has pressed on: His push into mortgages, stock brokerage, accounting for businesses, and investment advice propelled the Kansas City (Mo.) company's quarterly net profits more than sixfold, to $29.6 million, in its third fiscal quarter ended Jan. 31.

The expansion efforts have met with apparent success--at least for now. Prompted by the Federal Reserve's 11 interest rate cuts last year, earnings in the mortgage business alone grew almost 60% last year--and through February, new mortgages are up a feverish 86% over 2001. Some 100,000 IRAs have been sold in the first two months of the current tax season, and a wealth-management program for investors launched in October signed up 3,248 accounts with $486 million in assets. Even the staid tax business has been a bonanza: The myriad changes in the tax code should continue to send taxpayers to Block's 9,000 offices en masse.

Investors took note. After languishing for years, the stock soared 117% in 2001--one of the top 10 best performers in the Standard & Poor's 500-stock index, which was down nearly 12% last year. Told by the company to look for more upside surprises this year, investors sent the stock to a 52-week high of around 50 on Mar. 1.

Still, it's far from clear that Ernst's forays will have staying power. Block's accounting and consulting operations are suffering from the decline in business spending and could take a hit from the Andersen fallout. Detroit's Olde Discount Corp., a broker Block bought for $850 million in 1999, is hurting because of a bumpy stock market. And the mortgage boom is likely to peter out when interest rates rise.

The signs of weakness are already showing. For the fiscal quarter ended Jan. 31, revenues at Block's investment-services unit fell 48%, to $61 million, as the average daily retail trading fell 36%. The consensus on Wall Street is that H&R Block will earn $425.8 million, a 50% upswing for fiscal 2002, which ends Apr. 30. But analysts expect earnings growth to slow sharply, to 6.2%, for a net profit of $452.1 million in fiscal 2003.

Alexander Paris Jr., director of research at Chicago's Barrington Research Associates Inc., is sticking to his $55 share-price target for 2002. Currently, the stock trades at a p-e of 27 times the last 12 months' earnings. "Early indications for all of Block's businesses are good, but we're going to need to see further progress if we're to remain bullish," he says. Douglas Grey of the 32-stock PBHG Clipper Focus Fund dumped Block in September because he viewed it as fully valued at below $40 a share.

Even the booming tax business--which still makes up 55% of Block's revenues and profits--is likely to slow. Revenues from tax preparation are expected to be up 13% this fiscal year and next but will return to more typical 6% growth by 2004. Block isn't as powerful in the do-it-yourself market for tax prep--largely an online business dominated by Intuit Inc. It accounts for only 5% of revenues, and its market share has been flat for three years.

Ernst concedes there's a long road ahead before his 17 million tax customers see Block as a one-stop financial shop. "It will be several years before our current expansion plans pay off," he says. But at least one investor looks willing to stick it out: Warren E. Buffett, who bought 8.4% of the company early last year and added 230,000 more shares last quarter. That's a big vote of confidence. But if Block can't keep delivering, an exodus from the stock is another certainty he can count on.

By Pallavi Gogoi in Chicago

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