First, let's look at some of the risks facing this company:
1) Mortgage Put-Backs
The most immediate market fear with respect to this company is the same one facing many US financials today. During the housing bubble, Block used to originate mortgages. (It has since divested that operation.) Buyers of those bad mortgages (of which over $30 billion remain outstanding, down from $50 billion two years ago) can force Block to pay penalties or buy back mortgages where it can be proved that Block has made "valid breaches of representations and warranties".
The company originally set aside $243 million for this purpose, of which it has paid $55 million over the last two years based on a case-by-case examination of the loan documents. Recently, management has re-iterated that it is comfortable that the remaining $188 million reserve will cover future put-backs. But even if one doubles, triples or quadruples this reserve, it still doesn't justify the $4 billion in market cap this company has lost in the last few months!
Another issue facing this company is the fact that governments don't like some of the services Block provides and has sought ways to curb them. Block has settled many of the lawsuits it has faced, however, some remain outstanding. But the problem isn't just restricted to lawsuits. Recently, the IRS announced that it would be withholding key credit information about filers, which will make it harder for Block to provide loans to some of its clients. We've seen this issue of government interference before with another extremely cheap stock, but in Block's case, its regulatory-friendly services are worth way more than its peripherals. For example, Block stated that the credit information withholding by the IRS is likely to cost earnings about 5 cents per share this year.
3) Do-It-Yourself Online Filing
The main long-term issue facing this company is the fact that over time, tax filers are shifting online and away from bricks and mortar companies. Intuit (INTU) has been successful in growing the use of its Turbo Tax software, and Block's software unit has not been able to keep pace. But due to changes in the last couple of months (discussed below), Block may actually have a bright future in this area.
This brings us to the end of the section on risks. Now for the positives affecting this company:
1) Do-It-Yourself Online Filing
Two weeks ago, Block announced that it has merged with the company that produces TaxACT, tax filing software that 5 million Americans used last year to file returns. The entrepreneur who started that company in 1998 and has been leading it since will now head Block's digital business unit, with a separate P&L. Where Block couldn't succeed on its own, it has acquired capable management that can.
2) Weak Bricks & Mortar Competition
While the recession has taken a bite out of H&R Block, it has taken an even bigger bite out of the competition. The next largest retail filer, Jackson Hewitt (JTX), is having trouble just staying solvent. Its current ratio is well below 1, its debt levels relative to income are very high, and it continues to shut locations, which should allow Block to increase share. Block's net debt level is only about half of one year's worth of net income.
3) Free Mortgage Assets
The market is sour on the mortgage market, but Block continues to receive cash from mortgage assets that it owns itself (not to be confused with mortgages it has sold, as per risk #1). It owns over $550 million of mortgages, after allowances for impairment, that the investor is getting absolutely free at the current stock price. Cash flows from these assets can no doubt help cover shortfalls that may occur with respect to risk #1.
4) Shareholder Friendly
This company returns cash to shareholders. The dividend yield is almost 6%, and the company has bought back $400 million worth of shares in the last year. This is a signal that management doesn't just say that its put-back reserves are adequate; its actions suggest that it truly believes it. The chairman of the board of directors owns $130 million worth of the company.
5) Potential For Services Growth
Block is able to use its retail presence to introduce and further grow client services other than tax filings. One area that is particularly ripe for growth according to management is the company's debit card program, which is providing debit services to tax clients who do not have bank accounts.
Block's stock price has not been this low since 2001. Because sentiment in the mortgage space is so poor, investors are perhaps being offered the opportunity to buy a strong franchise at a terrific price.
Disclosure: Author has a long position in shares of HRB