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Benjamin Franklin wrote, “In this world nothing can be said to be certain, except
death and taxes.” While the certainty of taxes might have been a sound Company: H&R
justification for H&R Block’s (“HRB” or “the Company”) existence back when it Block
initially IPO’d in 1962, more recent structural trends are leading to the
company’s demise. H&R Block has attempted to hide its coming death by Ticker: HRB
employing a number of shenanigans to embellish its financials. However, Industry:
HRB’s death is certain as the stock stands to lose over 48% of its value. We Consumer
initiate on HRB with a $13.72 price target. Discretionary
H&R Block is a melting ice cube as volumes in its main business line have been Stock Price as of
declining. To mask its grim future from the financial community, the Company 10/3/2017:
has introduced new offerings. As we discovered, one of these offerings, HRB’s $26.59
Tax Identity Shield, a product that, ironically, is meant to prevent identity theft
is the subject of data breaches due to its association with Equifax (EFX). Once Market
this is exposed, not only will all Tax Identity Shield revenue be wiped out, but Cap:$5.56bn
the Company will experience customer losses across all products as potential
Daily Volume:
clients will be hesitant to trust H&R Block with their taxes.
2,939,904 (3
In addition to the now obsolete Tax Identity Shield product, HRB’s other month avg.)
offerings have proven to be fairly insignificant to H&R Block’s business.
Price Target:
However, these products and their associated accounting shenanigans have
been used to produce the illusion of topline growth, overstate earnings, and
understate risk at H&R Block. In this report, we will show:

1. H&R Block’s main source of revenue is declining as structural trends have
led to precipitous declines in HRB assisted return volumes. HRB’s DIY
offering is losing market share to its competitors.
2. HRB’s Tax Identity Shield (“TIS”), a product that is meant to prevent
identity theft has exposed HRB customer data to the Equifax data breach.
Not only does this render TIS obsolete, but it will likely lead to customer
attrition in all areas of HRB’s business.
3. HRB overstated earnings by underprovisioning for its EA program.
4. HRB underprovisioned for its Refund Advance Loans which could result in
significant charges down the line.
5. HRB’s Emerald Prepaid Mastercard revenues are at risk of a 50% reduction
due to new CFPB rules going into effect in 2018.

H&R Block’s Main Source of Revenue is Declining
Assisted income tax preparation, H&R Block’s main source of revenue, has been precipitously declining
for a number of years despite an increase in the number of federal returns filed1 per the graph below:

As can be seen from the following graph2 total assisted returns filed with the IRS have declined at the
expense of DIY filings which have seen a steady increase.

Additionally, HRB has not kept pace with the increase in DIY filers despite having their own DIY software
solution. As can be seen from the above graph, total DIY as a percentage of filings increased four
percent from 2012 to 2016 while HRB’s share only went up by 29 basis points over that same time

Even if HRB improved its DIY business, which is unlikely given Intuit Turbo Tax’s stronghold on the
space, the general trend away from assisted returns is especially troubling for HRB. This is because HRB
generates in excess of seven and a half times more revenue on an assisted tax return than one filed

US federal taxes filed: based on cumulative Forms 1040 processed by the IRS on or before week 21 of the calendar year. Source:
Wells Fargo Intuit research report dated 9/21/2017, HRB filings

using its DIY software. [NB: According to its 2017 10-K, HRB charged on average $237.29 for assisted
return preparation in its company-owned locations versus the $31.34 it charged for DIY product].

In response to declining assisted return volumes, HRB has attempted to slow the associated revenue
deterioration by simply increasing the price that it charges for assisted tax preparation. However, given
the increasing competition in the space, as well as the potential for a more simplified tax return process
due to tax reform, continued price increases are not sustainable. HRB witnessed this in FY 2016 in its
DIY product when it raised prices and saw a decrease is DIY volumes, forcing it to drop prices by nearly
10% in the subsequent year to stem DIY volume losses.

Given the dim prospects in its core product, HRB has introduced a variety of ancillary offerings to its tax
preparation clients to offset weakness in the assisted return business. However, as we will demonstrate,
many of these offerings are either becoming obsolete or are improperly accounted for resulting in
overstated earnings and understated risk.

Tax Identity Shield Product is Exposed to Equifax
As we just demonstrated, HRB is already having a difficult time retaining and acquiring clients. However,
we think that this problem will be greatly exacerbated as the Company’s association with Equifax (EFX)
will lead to massive customer losses and revenue declines across all of its product categories.

H&R Block customers are exposed to the EFX breach through HRB’s Tax Identity Shield (“TIS”) product.
Ironically, TIS was introduced in FY 2015 to “offer protection against tax identity fraud” to HRB clients
for an additional fee.

In an attempt to learn more about the TIS product, we found that H&R Block proudly partners with
Equifax on this offering. Although HRB has been silent on this fact since the massive Equifax data breach
in September, evidence of this partnership can be widely found, as evidenced below3:


A simple Google search confirmed that the relationship between HRB’s TIS and EFX is quite strong:

As a result of HRB’s Equifax partnership in the Tax identity Shield offering, clients who payed extra to
have their identity protected actually may have ending up exposing themselves to identity fraud.
According to HRB franchisees , HRB’s corporate office has failed to notify clients about this potential

Considering TIS’ association with Equifax, we think it is safe to assume that no competent person, and
especially an HRB client who was already so concerned with identity fraud that they elected to pay extra
for HRB’s Tax Identity Shield, will pay for this service in the future. We believe that 100% of the revenues
associated with this product will go away.

According to an excerpt from HRB’s 2017 10K, reproduced below, approximately $9.6mm of revenue
can be attributed to the TIS product.

Assuming that 100% of TIS revenue flows through to margin, based on 2017 numbers, the elimination of
this revenue stream would have a $0.03 impact on EPS as shown below:

In addition, we believe that after this breach, many HRB clients will think twice about trusting H&R Block
with their taxes which contain numerous personal data. As such, we belive that HRB will experience
increased customer churn across all areas of its business as a result of its EQX exposure.

HRB’s Earnings are Overstated Due to Underprovisioning for the Emerald Advance Program

In addition to extracting money from customers to protect (or in HRB’s case, disseminate) their personal
data, HRB also offers other products such as Emerald Advance loans (“EA”) to its tax clients. EAs are
unsecured lines of credit that HRB offers through BOFI. While the EAs are originated by BOFI, BOFI only
retains 10% of the Emerald Advance and sells the remaining 90% to HRB. According to HRB’s 10K, EA
balances require an annual paydown on February 15th, and any amounts unpaid are placed on non-
accrual status as of March 1st4. Based on an excerpt from HRB’s 2017 10-K, reproduced below, nearly
90% of HRB’s EAs were impaired!

2017 HRB 10-K, page 41

Not only is it troublesome that HRB continues to offer EA loans to its clients despite the company’s
seeming inability to collect on them, but what is even more shocking is how HRB provisions for these
loans. If we look at the Company’s financials, we will see that HRB’s allowance for doubtful accounts for
EA as a percentage of EA Receivables has precipitously dropped off in FY 2017:

HRB’s allowance for doubtful accounts flows through to the income statement as “provision for bad
debt” as demonstrated below. As such, underprovisioning leads HRB to overstate its earnings.

Had HRB provisioned for EA bad debt in a manner consistent with prior years, 2017 EPS would have
been lower by $0.06 as demonstrated below:

Gross Under Provisioning For Refund Advance Loans Understates Obligations
In addition to underprovisioning for its EA program, HRB has also taken a very aggressive stance when
provisioning for its Refund Advance Loan program. HRB started offering interest-free Refund Advance
(“RA”) Loans to its assisted-tax clients to bridge the gap between the time clients file their return and
receive their refund. According to HRB’s CFO, “even though [RA] is not directly attributable from a
revenue perspective, it brings clients into the door” (HRB Q12018 earnings call). In addition, “the launch
of Refund Advance also helped [HRB] drive an increase in the number of Emerald Cards issued this year,
resulting in a 140 basis-point increase in [their] card attach rate” (HRB Q42017 earnings call).

According to HRB’s Q4 2017 Earnings call, approximately $700mm of loans was funded through the RA
program for FY 2017. Funding for the loans was provided by Metabank and BOFI. Block Financial, a
subsidiary of HRB, provided Metabank and BOFI with limited guaranties up to $73mm which would
cover loan losses. All of this seems fine until we take a closer look at how HRB provisioned for the RA

Loans in its financials, detailed below:

HRB’s partners in the RA program (Metabank and BOFI) demanded that HRB guarantee in excess of 10%
of the total loans to cover loan losses. Given that client eligibility for the RA loans was determined by
Metabank, it can be assumed that $73mm represented a somewhat accurate estimate of expected loan
losses when taking into consideration the nature of the loans and the borrower pool. In spite of this, in
its own financials, HRB only thought it necessary to provision an estimated liability equal to 0.10% of the
total RA loans, significantly understating potential losses of this program. We find this mismatch quite
puzzeling. Had HRB accounted for this provision consistently, its near term total contractual cash
obligations would have increased by 22 percent!

Unlike the EA provision, HRB’s provision guaranty does not flow through to the income statement.
However, if it turns out that the $720,000 that HRB provisioned for $700mm of RA loans is too low, we
may see a substantial charge in subsequent years.

New CFPB Rules Put Emerald Prepaid Mastercard Revenues at Risk
The Emerald Prepaid Mastercard is another ancillary product upon which HRB relies to mask its
deteriorating core business. This card allows HRB clients to receive their tax refunds from the IRS
directly on a prepaid debit card. This card can also be used to make everyday purchases, pay bills and
make ATM withdrawals.

However, according to feedback from HRB’s customers, the Emerald Prepaid Mastercard comes with a
number of drawbacks that are not clearly communicated or maybe intentionally left out when
customers elect to receive their refund on this card. H&R Block charges customers a fee every time they
use this card to withdraw funds or check their balance at any ATM. If the card is declined, the customer
will also be charged. If the customer wants to pay a bill online using the Emerald Mastercard, a fee will
also be applied. If the customer gets tired of paying fees and lets the card lie dormant in their wallet for
a few months, HRB will charge them a monthly inactivity fee. These exorbitant charges associated with
the Emerald card have led HRB to realize over $95mm of revenue in 2017.

Fortunately for consumers, and unfortunately for HRB, the CFPB has taken notice of the predatory
practices associated with prepaid cards. Starting on April 1, 2018, new rules imposed by the CFPB on
prepaid cards will eliminate many of the Emerald Prepaid Mastercard’s revenue streams by prohibiting
HRB from charging consumers for a number of the aforementioned services that customers currently

must pay for5. In addition, the CFPB will require that institutions provide standard, easy-to-understand
and upfront information regarding the prepaid cards. Once consumers are well informed about the
many drawbacks of the Emerald Prepaid Masterscard, they are likely to abstain from using the card for
activities that will require them to pay fees. The more likely scenario however is that HRB customers
will elect a different method to receive their tax refund altogether since there are a number of other
free and easy alternatives. Consequently, we conservatively estimate that at least 50% of revenues
associated with the Emerald Card are likely to go away.

Looking at the revenue disclosure around the Emerald Card from HRB’s 10K reproduced below, we see
that the $95.2mm of revenue recognized is net of related charges:

Assuming the net revenue amount is straight margin, a 50% reduction in Emerald Card revenues,
translates to a $0.15 reduction in EPS based on 2017 numbers.

Putting It All Together: HRB Stock has 48% Downside Risk
We value HRB by first forecasting revenues for each of its business segments. Forecasts are based on
arguments presented in our report, with corresponding page numbers.

Then, we get to net income by applying a pro-forma net income margin. We derive the 10% net income
margin by first figuring out what the net income margin would have been in 2017 (12.02%) if HRB did


not inflate results through various offerings and underprovisioning. We then consider the effect of
declining volumes and inability to raise prices on margins which gets us to a 10% pro-forma net income
margin from which we forecast a 2018FY net income.

We use a 10x P/E multiple to account for the Company’s increased risk due to underprovisioning for its
ancillary products which until now has not been recognized by the street. In addition, we believe that
this multiple is warranted by shrinking top line growth due to structural changes and lack of traction in
many of the Company’s additional offerings.


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