November 12, 2002 7:00 PM
H&R & Bezos: Chips off the Blocks
Market Recap
Upbeat comments from Cisco and Oracle helped bolster tech stocks today while a Philip Morris warning took some steam out of the Dow. Additionally, a couple of Fed members were out talking up last weeks Fed cut. Following a dull speech Fed Ferguson had this to say in a Q&A session:
“I do not think that macroeconomic outcomes will be sufficiently adverse to place us in imminent danger of hitting the so-called zero bound on nominal interest rates. Even more remote, is the possibility that monetary policy will be unable to prevent deflation.”
Unfortunately, what Mr. Ferguson didn’t comment on was the fact that the Fed is already on the path to a ‘zero bound’ interest rates. To be sure, by forcing more debt down the consumer’s throat the Fed knows this will eventually choke consumer demand. And while the Fed hopes that demand can sprout elsewhere to compensate for weaker consumer demand, that the Federal Funds rate has to be continually cut in an attempt to find this elusive growth agent is proof that rates are headed towards zero.
As for Fed policy preventing deflation – I agree. If the Fed is stubborn enough there is no possible way for deflation to occur. It is worth remembering, however, that when calculated steps are taken to deflate the dollar in order to prevent price inflation that hyperinflation can occur. This is not to say the U.S. dollar is going to lose much of its value inside of a short period of time. After all, the greenback is the most popular piece of paper in the world. Rather, that if lowering interest rates and deflating the dollar is the best idea the Fed has to combat price deflation they are no better than Japan.
Side note: The Fed should remember that their printing press cannot work any magic if investors begin to lose faith in the dollar.
Chips off of H&R’s Block
Since reaching an all time high of $53.50 in August tax service king-pin H&R Block has seen its share price decline by 45% ($29 was today’s low).
Inundated by a seemingly endless flow of negative news, including what the company called a ‘shocking’ lawsuit development and questionable return-on-sale accounting practices, is America’s largest tax preparer ripe for the picking?
To begin with, H&R Block is a cash cow that pays dividends: it is the dominate tax preparer, and the company consistently achieves double digit net margins while paying out 44% of net earnings in dividends (average for last 6 years.) Furthermore, Warren Buffett’s Berskshire owns 8.72% of the outstanding shares. Enough said.
However, Block’s current problems are not centered on the company’s ability to generate cash and pay dividends. Rather, two key issues have attacked its share price:
1) Court developments
2) Mortgage financing concerns
Court Developments
On November 1 Block responded to rumors and stated that litigation on its refund anticipation loans (RALs) would not have a material impact on its financial results. Less than 1-week later a Texas judge ruled (summary judgment), that Block would be on the hook for $75 million because it did no live up to the fiduciary duty it has with its clients. Put simply, Block customers got loans at high rates of interest for the amount they were going to refunded, and Block did not disclose the fees they received from the lending bank.
Following the news Block quickly responded with a conference call. And while the verdict is still out as to whether or not Block believes $75 million is ‘material’ (10% of 2002 net earnings), Block did disclose that more RAL related cases were pending. After this disclosure a new wave of class actions suits was filed last week. This time, it was investors wanting to be compensated for management not informing them of all the class action suits against the company:
“H & R Block failed to disclose that it faced over 20 class action lawsuits in which it was accused of charging excessive interest rates which amounted to a potential $2 billion”. Reuters
It is doubtful that HRB will be on the hook for $2 billion. It appears that this amount includes all fees and payments received during the period in question, and HRB has said that numerous courts have already stated that the company does not have a ‘fiduciary duty’ to its clients. That said, court developments for Block will heat up later this week as a nationwide Illinois class action suit (similar to Texas) resumes. Block has already received a favorable ruling in this case.
Mortgage Finance
The WSJ reported that Block’s mortgage business, which is geared primarily to ‘poor credit’ customers, is on pace to account for the majority of the company’s revenues this year. Further, the Journal noted that Block’s ‘gain-on-sale’ accounting policies could be question. Put simply, gain-on-sale estimates future revenues and could be impaired if the estimated revenues do not materialize.
The WSJ article hit HRB’s stock price today, but it is unlikely that this news means anything. Did shareholders not know that Block sold mortgages and used gain-on-sale accounting practices before today?
Conclusion
The sticking point for HRB is whether or not they have a fiduciary duty to their clients. The company is quick to state that they do not. However, the Texas ruling, and the fact that the companies business is becoming increasingly geared towards providing personal investment advice not just a 1-time tax service, suggests that they do.
If more courts begin to rule that Block has a fiduciary responsibility to its customers this could unleash another wave of class actions and/or civil suits. Furthermore, a fiduciary responsible Block would likely mean a change in the companies marketing strategies, and nagging costs to bring its operations up to certain standards.
In sum, if H&R Block could pay the $75 million right now and put their court troubles behind them the stock would be a screaming buy. However, lawyers cost money, the lawsuits are piling up, and $75 could simply be the tip of the iceberg. The mortgage finance risks are real, but not an outrageous surprise given that mortgage activity must inevitably slow.
HRB is certainly a company worth watching, as it is likely to remain a force in tax preparation for many years to come regardless of the court developments.
Amazon No Ruby
This time, Amazon has launched an Apparel division of its store (project Ruby), in which the consumer can choose from more than 400 different brands. Rather than try and sell Apparels at a profit, Amazon has a better idea: when you order $50 in Apparel merchandise you get a $30 to spend at Amazon! What a great deal!
That said, shareholders should be concerned about how Amazon is recording sales activity in their financial statements. Customers will pay for and receive $50 worth of merchandise before Christmas, but they will be forced to wait for their $30 certificate until the New Year (‘six weeks’). Amazon could not be reached for comment.
Incidentally, some people are still excited (7 buy ratings versus 1 sell) that Amazon can generate so much business ($1.1 billion in sales in 4Q01 alone). However, whether or not the company can generate business with MARGINS remains the real question.
With AMZN, investors are paying $7.5 billion for a company that has double the debt to its assets. As for Bezos, who says that X-mas will be OK, he continues to dump blocks of shares under his pre-existing plan. Sure, there is nothing wrong with this. That Bezos would rather do other things with his money than remain invested in Amazon probably means nothing. Right?.
As for project Ruby being an overnight success:
“We never expect very much benefit financially from anything brand new we do.” Bezos.
Take out the words ‘brand new’ and Bezos is about right.
New Rule: No Buy Backs when CEOs are selling
Here is an idea for the next SEC boss (assuming his job isn’t to do what corporate America wants him to do, of course): Don’t allow CEOs to sell their shares when a company is buying back stock.
Under such a rule companies would only enact buy backs when a stock laden CEO himself believes the stock is undervalued. What they would not do is announce massive buy back plans, issue and sell equally massive equity compensation packages, and let the chips fall where they may. What if Mr. DELL wants to sell his shares and he can no longer use company funds for stock buy backs? Well, the money could be used for dividends, debt retirement, capital investment, etc.
With so many people discussing killing the double dividend tax the above proposal would work wonders. It would force CEOs to actually try and do what is best for shareholders and not for themselves. Other derivatives of this rule would be to not allow companies with poorly rated debt to use money for buy backs, and don’t allow high P/E stocks to buy back shares.
Yes, these suggestions are little different, and everyone is more concerned about CEOs taking corporate loand, stock options, etc. However, once upon a time buy backs were a sacred thing, enacted by companies who firmly believed that their shares were below what they were worth. By contrast, sometime during the great bull market enacting corporate buy backs became a common business practice, and many investors have suffered because of this.
UST Inc.
Today Philip Morris warned and UST’s shares also dropped (a low $28.85). We do not believe that $28.85 warrants an immediate investment in UST given last weeks court developments.
Disclosure: Brady Willett does not have an investment position in any of the companies mentioned.
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