The Lingering Cloud Over H&R Block

Lawsuits hurt the storefront tax-preparer's stock, but now that the threat has receded, CEO Mark Ernst must still calm investors' jitters

By Pallavi Gogoi

There's nothing certain in life, the saying goes, except death and taxes. For H&R Block (HRB ), the nation's largest tax-preparer, that old saw has always been a steady moneymaker. But lately, Wall Street has been focused more on the burial aspect of that wisdom.

Witness all the dirt Wall Street recently threw on H&R Block, driving the share price down 34% in two weeks, to a low of $29 on Nov. 12. Investors were reacting to published reports that pending Texas-based class-action lawsuits could result in damages of as much as $2 billion. It turns out that estimate was way overblown: Block tentatively settled the Texas suits for up to $262 million on Nov. 19, and plans to take a $42 million pretax charge related to the settlement when it announces its fiscal second-quarter earnings on Nov. 26.

Still, that's not the end of the challenges facing the Kansas City (Mo.) outfit and Mark Ernst, 44, who took over as CEO in January, 2001. H&R Block's share price has rebounded crisply since the nosedive, closing at $38.40 on Nov. 25. But given that shares were trading at around $50 as late as September, investors still seem jittery.


  The starkest difficulty confronting Block remains litigation. It still faces class-action lawsuits that are pending in Alabama, Pennsylvania, New York, and other states, stemming from the company's controversial practice of making high-interest loans to customers that are secured by expected tax refunds. The loans, known as "rapid refunds" and offered by Block through banks, involve interest rates of more than 100% if calculated on an annualized basis.

About 30% of H&R Block's U.S. tax customers take the company up on its offer every year. And the loans are a source of fat profits. In its fiscal year ended April, 2001, Block earned $68 million in operating profits on loan revenues of $134 million, about 18% of its total black ink. Its profits from loans were not reported in 2002, but they must have been considerable, because loan revenues were up 20% from 2001, to $160 million. And Block earned a hefty $434 million on revenues of $3.3 billion in fiscal 2002.

Some aggrieved customers have sued, claiming Block was bound by law to tell them that the company was being paid finder's fees by the banks that administered the loan program. The company says it broke no laws in accepting the fees, but has since changed its policy to disclose them. And Block adds that it has not lost a single legal case over the issue in 12 years. Most of the suits were filed before 1996, when Block placed a clause in its loan contracts requiring customers to go to arbitration, rather than sue, in the event of a dispute.


  Block is trying hard to put such legal complaints behind it. In Illinois, it has entered into a $25 million settlement agreement with plaintiff lawyers that it would like to use as a national settlement model. A ruling on the settlement is expected in December from the U.S. District Court in Chicago. Despite all the litigation, however, Ernst says he's unwilling to give up the loans for fear his competitors will nab a significant number of his clients, 25% of whom say they come to Block because they are attracted by the "rapid cash" offer. However, he's willing to be more flexible on the pricing. "We will likely have lower prices on these products and give up some profitability," he says.

Ernst is also tackling another source of investor concern: Block's mortgage business, which expanded by 76% in 2002, bringing in revenues of $734 million and pretax income of $339 million, vs. $533 million from U.S. tax operations. Some critics maintain that Block is expanding into risky subprime lending -- which has proved an albatross for competitors such as Household International (HI ).

Block contends its screening process is stringent -- borrowers have an average annual income of $63,000 and may have a less than perfect credit record only if there is a "life event," such as a divorce or illness, in their backgrounds. Ernst acknowledges that the business' growth likely will slow if interest rates go back up, but doubts that will happen any time soon. "Besides," he adds, "we are not as susceptible, because the more volatile refinancing business makes up only 10% of our loans."


  Some analysts question whether Block can meet its ambitious growth goals without diversification into other services. "Tax-preparation grows annually at a rate of 2% to 3%, and that can't drive earnings 15%," says Alexander Paris Jr. of Chicago's Barrington Research. That's why Block started offering IRAs to taxpayers in the 2002 tax season -- and signed up 135,000 tax customers for the service, Ernest says. He hopes to sell at least 500,000 IRAs next year.

Block has also applied for a federal charter to start a bank to offer savings products to customers. However, Block has yet to demonstrate it can make money in its brokerage-services division, which posted a punishing $55 million loss in 2002 on revenues of $250 million. The upshot? Ernst has to tread carefully. And a lot will depend on next month's court ruling on the settlement. If favorable, it would allow Block to put many of its legal woes behind it. But with a little luck and the right timing, Block could emerge in good health after a very taxing year.

Gogoi writes for BusinessWeek from Chicago

Edited by Thane Peterson

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