H&R Block Stock: Overvalued And Risky (NYSE:HRB)

H&R Block (NYSE:HRB), or as many people may know it, TurboTax’s creators, has done quite well over the past few months as previous quarters’ numbers came in over expectations and the company guided for a rosy year ahead.

This is driven by factors like record participation in the jobs market, record low unemployment and more people doing their own taxes instead of through accountants, as the process through platforms like TurboTax makes it easier.

But there’s a reason why I expect the company’s year ahead to be challenging, and when combined with the fact that I believe the company is slightly overvalued after the surge in share price over the past few months – it presents a company which should be avoided as a long term investment and even potentially one where longer-term investors may be wise to take some profits off the table and move into some cash.

Recessionary Fears

Right now, the thesis for H&R Block is simple – record low unemployment means more people are working and filing their annual taxes, and given that the company’s TurboTax holds a significant market share – the company has done very well in the just-completed tax season.

But as we’ve seen in the past – what goes up must come down. As I believe an economic slowdown (or even a full-blown recession) may be in store in the coming year or two, unemployment should head up, especially when we’re at near-record labor force participation and more people are working than ever. For better or for worse.

So given that the company’s model works by losing money throughout the year but then making a boatload during 1 or maybe 2 quarters due to tax season, we won’t have any idea about the effects of a possible slowdown until tax season comes around.

One of the things we’ve seen in the past couple of weeks and months is that layoffs are beginning to take hold. Not in service jobs which are still short on labor, but in the higher-paying tech, engineering and healthcare sectors. While most service workers, which typically get laid off during sharper economic downturns when people stop spending at stores, restaurants, etc., are generally able to find and switch jobs more easily, higher earnings individuals typically can survive for a year on savings while they look for a different or better job.

This means, I believe, that if my projection for a slightly stronger-than-expected economic downturn occurs throughout the next year, that there will be, potentially, a significant drop in the amount of people filing their taxes through a service like TurboTax, which has a tiered payment system for different types of tax filings.

Beyond Macroeconomics: High Valuation

As the company’s share price rallied over the past few weeks on the news that they exceeded earnings and sales expectations, it has gotten to a territory befitting a company which is expected to grow at a nice sizable rate, with its forward price to earnings multiple heading over 11x.

The company’s share price rose from around $25.00 per share to over $40.00 per share, a 60% increase in value.

The problem is, growth doesn’t support that multiple, in my opinion, as the company is only projected to grow their sales by around 2.3% over the next 2 years. While analysts currently do project that net income will grow by 7% and 9% for 2023 and 2024, respectively, there doesn’t seem to be much evidence for that.

In the latest reporting year, the company’s gross profit margin fell to 45% from over 50% the year before that, signaling that while they may have brought in more revenues, they couldn’t translate new customers to any high-margin products.

At the same time, the company’s SG&A (selling, general and administrative) expenses rose from $594 million to $837 million, causing their operating income to actually decline by $60 million, despite revenues rising by almost $700 million year over year.

Therefore, there’s little for me out there to believe that the company will be able to grow their net income, or earnings per share, at a rate so much higher than their sales growth for that year – meaning that at a roughly 3% annual growth rate projection for earnings per share, an 11x forward multiple is high.

The Double Whammy Conclusion

I believe that the company is currently overvalued. If we take into account a 3% growth rate, my opinion is that the company should be trading at around 8x their forward earnings, projecting a fair value of around $32.00 per share at peak EPS projections of $4.09 for 2024.

That implies that the company is overvalued by as little as 22%.

That’s with current economic and fundamental standards. The company itself doesn’t hold much debt and has mitigated rising interest rates by lowering some debt and refinancing some other, all the while they hold a nice chunk of cash and equivalents, which currently stands at $885 million.

But in the event of an economic downturn, the company is highly susceptible to rising unemployment figures, which should add to the fact that they are currently overvalued, which I believe will cause the company’s stock price to easily underperform the broader market.

While the company does pay a nice and highly sustainable dividend yield of 2.8%, which has a payout ratio of about a third of earnings, I believe that not only is the company overvalued by about 25%, but that we’re likely going to see an economic downturn in the coming 18 to 24 months and with that – unemployment rising and less people filing their tax returns.

As a result, I have shifted my stance on the company’s near to long-term prospects from bullish-neutral to neutral-bearish and will be trimming my position in the company by about 75% and moving into cash.