Does the H&R Block Cloud Have a Silver Lining?

H&R Block (ticker: HRB) has fallen on hard times. Customers are due some $62.5 million dollars after settling a class action law suit against the largest tax preparer in the U.S.
It seems that Block was accused of violating consumer protection laws. The company offered fast money, called "Rapid Refunds," to customers expecting tax refunds. However, they were actually loans repaid by those refunds that charged interest rates of between 29 percent and 750 percent.
Not only that, the company recently revised its second quarter financial results to include bigger than previously reported losses related to Hurricanes Katrina and Rita.
So, for H&R Block, if it wasn't for bad news there would be no news at all. But what looks bad on the surface can spell opportunity for investors.
The truth of the matter is that H&R Block is a very good business that investors can purchase at a bargain price. We know it's a good business because it's earning a high rate of return on its own money. In what I think is sure to be the investment book of the year -- The Little Book That Beats The Market by Joel Greenblatt -- Greenblatt recognizes a good business by its return on capital. He takes earnings before interest and taxes (EBIT), and divides it by its net working capital plus its net fixed assets.
To determine H&R Block's return on capital, we would first determine its EBIT for the past four quarters -- about $1.04 billion. Then we would divide that figure by net working capital plus net fixed assets -- call it $1.2 billion. We get a return on capital of about 87%.
Forget the law suit. That's over and done with. Forget the hurricanes. The damage to Block caused by them is already done. Would you be interested in owning a partial interest in a business that gets a return on its own money of 87%? I would certainly think so.
Also, being in the tax preparation business, Block is a very seasonal business. It earns most of its money in the first quarter of the year -- the quarter we're about to enter.
After we find a good business, the next question is can we buy partial interest in this business at a bargain price? To determine that, Greenblatt uses earnings yield -- EBIT divided by enterprise value (market capitalization minus cash, plus debt). As a back-of-the-napkin calculation, let's call it 12%.
In other words, the company has returned economic profits on their shares of 12%. Compare that with the rate that an investor could get on a 10-year Treasury note of about 4.3% and H&R Block looks like it's being offered at a bargain price.
Of course, there are no guarantees and there are risks. If you want no risk, take the 4.3% that you can get on a Treasury note and hold it for ten years. Also, this article should certainly not be construed as investment advice. It is simply an illustration of how great investors like Joel Greenblatt get great returns (Greenblatt is the managing partner of Gotham Capital with average annualized returns of 40% for over twenty years).
They buy shares of good businesses when they can buy them cheap. Despite its recent troubles, H&R Block certainly seems to qualify as such an investment.
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