DBRS Confirms H&R Block, Inc. at BBB (high), Trend Stable; Withdraws Ratings

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 Issuer Rating of BBB (high) and Short-Term Issuer Rating of R-2 (high). The trend on all ratings is Stable. Subsequent to the confirmation, DBRS has withdrawn the Company’s ratings.

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

DBRS sees Block’s 2012 tax season results as evidencing that the benefits are being captured of the Company’s successful execution on client service initiatives and client acquisition programs put in place over the last two tax seasons. Block estimates that its U.S. market share increased 30 basis points in the 2012 tax season to a market leading 16% of an IRS estimate of individual tax returns filed by April 30, 2012. Importantly from DBRS’s perspective, the 2012 tax season represents the second consecutive year of market share gains following two years of declining filings and market share. During the 2012 tax season, Block’s U.S. tax returns prepared grew 4% to 22.3 million returns, notably outpacing the estimated 2% growth in overall IRS filings.

Within the growth in U.S. tax returns, Block reported solid gains in the fast growing digital tax space. In the past, DBRS had considered the Company’s limited success in leveraging its strong brand name in the digital space as a challenge to the franchise. However, DBRS sees indications that the Company’s efforts to leverage its brand in this important market segment and investment in developing a more client friendly platform are allowing the Company to capture growth opportunities in the digital tax preparation market. In tax season 2012, Block grew on-line digital returns 11% year-on-year, the second consecutive year of double-digit growth. As a result of this growth, the Company gained 30 basis points of market share in digital. Nonetheless, there is more work to be done as there is significant market share differential between Block and its largest competitor. Accordingly, DBRS expects continued focus on this business line. While Block’s very solid operating results for FY2012 demonstrate that the Company is successfully defending its strong franchise and executing on plans to grow the digital platform, translating the positive momentum into revenue and profitability growth is viewed by DBRS as a key near-term challenge.

Even with slightly lower results in FY2012, Block’s solid earnings generation ability underpins the ratings. Specifically, for FY2012, Block generated pre-tax income from continuing operations of $576.1 million, 8% lower than FY2011, reflecting slightly lower revenue and broadly stable expenses. For the year ending April 30, 2012, Block generated total revenues of $2.9 billion, 2% lower than FY2011, primarily due to a promotional offering on RACs and lower interest income on Emerald Advances owed to tighter underwriting standards. These constraints on revenue growth were partially offset by higher Emerald Card fee income on higher volumes and lower bad debt expense resulting from the aforementioned tighter underwriting standards on Emerald Advances. Total expenses were essentially unchanged year-on-year at $2.3 billion. The expense base benefited from the lower bad debt expense and a reduction in occupancy expense which offset incremental severance costs and a 15% increase in marketing and advertising expense to $278.2 million. Given the continuing difficult labor market conditions for lower AGI filers, and Block’s lack of ability to offer RAL product in a competitive marketplace, DBRS sees Block’s financial performance in FY2012 as demonstrating the resiliency and predictability of the Company’s revenue and earnings generating capacity.

While Block’s low financial risk profile is a factor in the ratings, managing the exposure to the legacy mortgage operations remains a risk. While Sand Canyon (formerly Option One) ceased mortgage originations in 2007 and sold its mortgage servicing operations in April 2008, repurchase liability for breach of representations and warranties remains. Claims activity increased markedly in FY2012 to $1.1 billion from a modest $218 million in FY2011. Although claims activity varies from period to period, Block believes the year-on-year increase partially reflects potential expiration of statues of limitations. Importantly, DBRS notes that during FY2012, Sand Canyon denied approximately 98% of all claims reviewed. At April 30, 2012, total claims of $618 million remained subject to review and repurchase reserves totaled $130.0 million. Moreover, Sand Canyon had total equity of $265 million at the end of April 2012. At April 30, 2012, H&R Block Bank held $429.3 million of gross mortgage loans in its held for investment portfolio, of which 59% were originated by the Company’s discontinued Sand Canyon Corporation.

The Company continues to maintain a prudent and well-managed financial risk profile. Liquidity is supported by Block’s $1.7 billion committed line of credit which expires in July 2013. DBRS notes that the Company has begun to discuss renewing the facility with the expectation of replacing the $500 million minimum equity covenant currently in place with leverage and cash flow tests. Further, DBRS notes that the Company has $600 million of medium-term notes due in January 2013. However, refinancing risk is mitigated by the $1.4 billion of available liquidity as of April 30, 2012, as well as the committed line of credit. As such, DBRS sees Block as having sufficient liquidity to meet the forthcoming debt maturities and meet working capital needs. With total equity of $1.3 billion at the end of FY2012, capital is deemed acceptable given the low risk profile of Block. DBRS understands that the Company’s new management team is reviewing the appropriate capital structure for Block following the disposal of the riskier, more capital intensive non-core businesses. Given Block’s stated intention to focus on its traditional retail tax and growing digital tax businesses, DBRS expects a balanced approach in regards to capital allocation and would be concerned should leverage increase notably.

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

The principal applicable 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 company documents. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: David Laterza
Rating Committee Chair: Alan G. Reid
Initial Rating Date: May 16, 2001
Most Recent Rating Update: October 5, 2011

For additional information on this rating, please refer to the linking document under Related Research.