H&R Block

H&R Block, the tax preparation company, filed its 10-Q for the second quarter last week. This quarter is normally uneventful for investors, as instead they look ahead to tax filing season next quarter (representing about 60% of revenues for the entire year.)

However Q2 is typically where the balance sheet is most active, as the company makes loans and advances to customers over the holiday season (traditionally many of these would be secured on future tax receipts).

In the recent filing, our system picked up a 20% increase in the level of receivables YoY. The growth was entirely driven by the “Emerald Advance” product, which has risen 30% from $271m last year to $356m this year. The company called out this trend on the earnings call, claiming that it “bodes well” for the tax season.

They go on to explain that they have transitioned the product from a “line of credit” to a “short-term loan” with “flexible repayment options” (see extract from Q2 presentation below).

Further detail provided in the 10-Q filing explaines that these loans are being offered in amounts up to $1,300 (previously $1000) and repayment is due in full by March 31 (previously February 15)

While the loans are made by their banking partner, Pathward, H&R Block acquire a 90% participation interest in each loan, therefore the majority of the risk remains with H&R Block, even if Pathward are the originator here.

All else equal, the combination of higher value loans and longer maturities should likely result in a higher default rate. Consider also that these loans are typically advanced to low-income households and that interest rates are higher than a year ago, you would imagine this should necessitate a larger buffer for credit losses. In fact, as the disclosure below shows, the allowance for credit losses has declined YoY, from $26m (or 9.7% of EA receivables) to $17m (only 4.9% of EA receivables).

Given this, investors might ask if the company has adequately provided for these loans? Furthermore where a company offers a financial product alongside a core product (potentially as a way to cross-sell the core product), rapid expansion of the balance sheet should be viewed with caution. In a bid to secure higher growth on the core business, it is all too easy for companies to become overly aggressive in the short-term, ignoring the longer-term impact of bad credit. Given limited details disclosed in the 10-Q, we think investors should be quizzing management on the nature of their relationship with Pathway and the terms of the new agreement referred to in the disclosure here.