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Should I Do It? H&R Block

The tax-prep giant has myriad problems, including the inability to accurately calculate its own taxes.

Et tu, Eliot?

H&R Block

(HRB) - Get H&R Block, Inc. Report

investors received a rude awakening on the Ides of March. On March 15, New York Attorney General Eliot Spitzer filed a $250 million civil lawsuit against the country's largest tax preparer, claiming the company was charging exorbitant fees for its "Express IRA" service. H&R Block, which prepares 20 million tax returns each year, sold this product to some 500,000 of its clients, allowing them to roll expected tax refunds into retirement accounts.

The stock fell nearly 7% on March 15 and is off 14% for the year at Tuesday's closing price of $21.13. This slide comes after H&R Block generated a 13.9% compounded annual total return for investors over the past five years. The company's earnings trajectory has seen a similar descent. After growing per-share profit at a compounded annual growth rate of 29% from 1998 to 2004, H&R Block is on track to post its second straight annual earnings decline in 2006.

So should readers buy H&R Block at Tuesday's closing price? In other words (

let's all say it together!

), should I do it?

Repeat Offender

It would be one thing if the Express IRA issue was H&R Block's first recent mistake. But only three weeks earlier, the company warned that fiscal third-quarter earnings fell 31% annually to 19 cents a share, well short of the 26-cent consensus estimate. Management also cut full-year earnings guidance 15%, to $1.65 from $1.85 a share.

The real kicker? The company miscalculated its taxes, inflating earnings by $32 million. The company will restate results for fiscal years 2004 and 2005, as well as for the first two quarters of fiscal 2006, to correct the error. Last August, the firm said its auditor found a "material weakness'' in the firm's accounting for income taxes. No kidding.

H&R Block is losing market share to

Jackson Hewitt


-- its closest competitor -- as well to tax-software maker


(INTU) - Get Intuit Inc. Report

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, which caters more to the do-it-yourself crowd. In addition, H&R Block said it lost 250,000 customers in early January alone because of technical glitches. It's also worth noting that H&R Block received 28% of its total 2005 revenue from mortgage-lending operations, a division that saw sales decline 20% year over year in the most recent quarter.

To view David Peltier's video take of this column, click here


Adding insult to injury, the Spitzer suit doesn't represent the first time the company has run into legal trouble. Just in December, H&R Block settled class-action suits across 26 states for $62.5 million claiming that the company falsely marketed its pre-refund loans. On Feb. 15, California Attorney General Bill Lockyer filed similar claims.

The bulls will argue that H&R Block sports a hefty 2.3% dividend yield, some 50 basis points above what the average

S&P 500

stock offers. The company has raised its payout every year since 1998 and can comfortably cover the payment 3.4 times with expected 2006 earnings of $1.70 a share.

According to the latest

Securities and Exchange Commission

filings, Warren Buffett's

Berkshire Hathaway

(BRK.A) - Get Berkshire Hathaway Inc. Class A Report

was one of H&R Block's largest shareholders. Buffet still controls 5.7% of the company, though Berkshire sold a third of its stake last summer. How can you bet against the Oracle of Omaha, right?

I admit, H&R Block's 12.4 price-to-earnings ratio is attractive on the surface. But what this valuation doesn't reflect is just how much the company's business will be affected by the New York attorney general's investigation. Just ask

Marsh & McLennan

(MMC) - Get Marsh & McLennan Companies, Inc. Report

, whose insurance business and share price have not been able to sustain any type of recovery since Spitzer probed the company's sales-kickback program.

In my opinion, the fact that H&R Block's earnings and legal problems don't seem to have spread to anyone else in the industry does not bode well for the stock's near-term performance. If the company lost market share because of some technical glitches earlier this year, what's to stop other folks from jumping ship to one of several competitors, large and small, that offer a similar service at a similar price?

In H&R Block's business, a trustworthy image is very important, and I believe the company's reputation has been tarnished by the multiple issues mentioned above. With that in mind, readers should avoid the stock at current levels, as it may continue to trend lower into the high teens over the coming months.

David Peltier is a research associate at In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier appreciates your feedback;

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