DBRS Confirms H&R Block, Inc. Issuer Rating at BBB (high), Trend Stable

DBRS Inc. (DBRS) has today confirmed the ratings of H&R Block, Inc. (Block or the Company) and its subsidiaries, Block Financial Corporation, LLC and H&R Block Canada, Inc., including its long-term ratings of BBB (high) and short-term ratings of R-2 (high). The trend on all ratings is Stable.

In confirming the ratings, DBRS recognizes the substantial strength of Block’s well-established franchise and leading market position within the tax preparation business and its significant cash flow generating ability. Moreover, the Company’s sound earnings generation power and the low financial risk profile are factors in the rating.

The ratings also consider Block’s letter of intent to sell its RSM McGladrey (RSM) unit to McGladrey & Pullen for total consideration of $610 million. DBRS views the potential sale of RSM as rating neutral at the present time. However, in DBRS’s view the exit of this non-core business could be ultimately a long term positive for Block. While the transaction removes RSM’s revenue, which in total accounted for some 22% of Company-wide revenue in fiscal year 2011, the potential sale only removes approximately 7% of pre-tax earnings. Importantly, in DBRS’s opinion, this potential transaction will allow Block’s management to dedicate all its resources and focus on investing and growing its higher-margin core retail tax services business. Given Block’s stated intentions of focusing on the retail tax and related businesses, DBRS expects a balanced approach in regards to the use of the proceeds, with the majority anticipated being reinvested into the business.

Important to the rating, Block reversed the negative trajectory in operating performance. During tax season 2011, Block gained market share in retail tax following two consecutive years of market share loss. To this end, Block’s U.S. tax returns grew 6.5% to 21.4 million returns, notably outpacing the estimated 1% growth in overall IRS filings. As a result, Block’s leading market share increased 80 basis points to 16.4% of an IRS estimate of individual tax returns filed by April 30, 2011. Within the growth in U.S. tax returns, Block reported solid gains in the fast growing digital tax space. DBRS had traditionally considered the Company’s limited success in leveraging its strong brand name in the digital space as a challenge to the franchise. However, with 29% growth in on-line digital returns and 90 basis points of market share gain, DBRS sees indications that the Company has begun to leverage its strong brand name and capture growth opportunities in the digital tax preparation market. Nonetheless, there is more work to be done as there is significant market share differential between Block and its next largest competitor. Accordingly, DBRS expects continued focus on this business line. While Block’s very solid operating results for FY2011 evidence that the Company is successfully defending its strong franchise, translating the positive momentum into revenue and profitability growth is viewed by DBRS as a key near-term challenge.

Block’s solid earnings generation ability is a factor underpinning the ratings. For FY2011, Block generated net income from continuing operations of $419.4 million, a 14% decline from the prior year. However, adjusted for litigation expense and other nonrecurring items, net income from continuing operations was largely unchanged at $470.6 million. Total revenue generated was $3.8 billion, only 2.6% lower than FY2010, despite the inability to offer RAL product and the sale of 280 company-owned locations to franchisees. While the absence of RAL product resulted in Block forgoing the $146 million in RAL-related revenue generated in the prior year, this was partially offset by a $94 million increase in fees earned on refund anticipation checks (RACs) and a $16 million increase in interest income earned on Emerald Advances. Given the external headwinds Block faced in FY2011 including the continuing stressed labor market conditions for lower AGI filers, and Block’s lack of ability to offer RAL product, DBRS sees Block’s financial performance in FY 2011 as demonstrating the resiliency and predictability of the Company’s revenue and earnings generating capacity.

While Block’s low financial risk profile is reflected in the ratings, managing the exposure to the legacy mortgage operations remains a risk. Therefore managing this risk is considered a challenge for Block. At July 31, 2011, H&R Block Bank held $554.0 million of gross mortgage loans in its held for investment portfolio, of which 63% were originated by the Company’s discontinued Sand Canyon Corporation (formerly Option One). Moreover, while Block ceased mortgage originations in 2007 and sold its mortgage servicing operations in April 2008, repurchase liability for breach of representations and warranties remain. Claims repurchase activity remains modest at $218 million in FY2011 compared to $145 million in FY2010 and $432 million in FY2009. Importantly, on a quarterly basis there is no discernable acceleration in the pace of repurchase activity. During 1Q FY12, $31 million of claims were received, which is lower on a linked quarter basis and year-on-year basis. On July 31, 2011 repurchase reserves totaled $125.8 million, which DBRS views as acceptable given the current level of claim activity. Nonetheless, DBRS continues to monitor this situation.

The Stable trend reflects DBRS’s expectation that Block will continue to generate substantial revenue and earnings from the core tax business. Further, DBRS sees Block capturing additional market share in retail tax and digital tax in the upcoming tax season as the Company builds on the solid foundation established in tax season 2011. These expectations are despite uncertainties regarding the sustainability and strength of the economic recovery and still weak labor market, which in DBRS’s opinion, will likely result in modest growth in total IRS tax returns filed for the 2012 tax season.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable rating methodology is Rating Finance Companies Operating in the United States, which can be found on our website under methodologies.

The sources of information used for this rating include publicly available company documents. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: Steve Picarillo
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 16 May 2001
Most Recent Rating Update: 27 August 2010