Taxing Times at H&R Block
CEO MARK ERNST promised to turn the nation's largest tax preparer into a year-round financial powerhouse. Now Block's new businesses are failing, and old clients are fleeing. Can he turn it around?

(FORTUNE Magazine) – IT'S TAX SEASON, WHICH TYPICALLY means one thing for H&R Block: It's making buckets of money. For 50 years the company has dominated the tax-preparation business, filling out returns for mainstream Americans through its network of no-frills tax offices. Dull as that may seem, it's always been a gem of a business. Thanks to Uncle Sam's endless tinkering with the tax code, the Kansas City, Mo., company receives an annuity-like revenue stream from customers. This year Block estimates that it will help more than 19 million taxpayers prepare their returns either in person, with computer software, or over the Internet. All told, it will complete one out of every five commercially prepared tax returns filed with the IRS.

If those numbers don't grab you, consider these: With more than 11,000 tax offices scattered across all 50 states, Block has built an empire that rivals any chain in the land. In number of locations, the tax preparer dwarfs Barnes & Noble (2,356 U.S. stores). It crushes Gap (3,051). It even beats Starbucks (6,409). In fact, the only chain that significantly outnumbers it is McDonald's (13,673), although Block is gaining.

Which brings us to the most surprising fact of all: H&R Block is hitting the skids. Hard. Four years after Mark Ernst took over as CEO and vowed to turn the company into a "year-round financial partner" offering mortgages, IRAs, and investment products, the majority of Block's businesses are ailing. And it's no case of the sniffles. The problems are ICU-bad.

The core tax unit is losing customers to feisty competitors that offer cheaper services and shorter lines. Meanwhile, newer businesses that Ernst plunged Block into are doing worse. Profits are plummeting at the mortgage division as the refinancing boom peters out. And the financial-advisors unit is a black hole, losing more than a quarter-billion dollars in the past four years.

In late February, Block's beleaguered shareholders finally got some relief when the company beat expectations by reporting only a 14% drop in third-quarter earnings, and its stock rose 10% in a day. Block beat analysts' gloomy forecasts in part because a gimmicky scratch-off game offering customers a chance to double their tax refunds had lured in slightly more people than expected. But Block shares, at $52, are still 15% off their 2004 high. And management has made it clear that the tax unit's problems are by no means solved.

More bad news is coming. For the first time in a decade Block is expected to report a sharp drop in annual profits when it releases its fiscal 2005 results in June. A federal class-action suit against Block, scheduled for trial later this year, alleges that the company tricked as many as 17 million customers into buying refund-anticipation loans, which typically charge borrowers triple-digit interest rates for providing their tax refunds early. (Block believes the case lacks merit and will defend itself in court.) And some Wall Street analysts speculate that Block will dump its ailing financial-advisors unit before the end of the year. If it does, it would be an astonishing admission of failure for Ernst, who has staked his career on the unit's success.

A onetime hotshot at American Express, Ernst, 46, has lately found himself in the uncomfortable position of apologizing to Wall Street. At the company's annual investor conference in January, he gave himself and top managers a grade of C for delivering results. "We are clearly not making the kind of progress we expect we should," he said. In fact, Block is no closer to becoming a full-fledged financial services firm than it was when Ernst became CEO four years ago.

STELLAR AS THE TAX-PREP BUSINESS IS, it's also seasonal. The tax unit accounts for about half of Block's $4.3 billion in sales; more than 70% of those sales and virtually all the unit's profits come in the company's fiscal fourth quarter, which spans the key February through April tax-filing period.

Co-founder Henry Bloch (pronounced "block," thus the company name) tried expanding into other businesses, such as legal services, back in the 1970s. But the bookish mathematician never managed to diversify the company's core operations. (Henry continues to serve as honorary chairman; brother and co-founder Richard retired in 1969 and died in 2004.)

Mark Ernst dedicated himself to expanding the company soon after joining it as chief operating officer in 1998. The son of an Iowa tax preparer, Ernst was a rising star at American Express, where he spearheaded its campaign to acquire several regional accounting firms.

At Block, Ernst plunged the company into the discount-brokerage business, orchestrating the December 1999 acquisition of Olde Financial. Investors hated the deal and sent Block shares tumbling nearly 20% over the next several days. Unbowed, Ernst and his team went ahead with the purchase and a month later launched a $100 million marketing campaign to promote Block as a one-stop financial shop.

Today the financial-advisors unit, as the brokerage business is now called, is a money pit. It has lost a staggering $330 million in the past four years--and it's still not clear it can ever turn a profit. This past December, Block received a well-publicized black eye when it agreed to pay a $500,000 fine to settle with the National Association of Securities Dealers, which charged that two of the company's brokers had allowed a hedge fund to conduct improper trading in mutual fund shares. Brian Nygaard, the unit's CEO, resigned in January, citing personal reasons.

The bigger concern is that Block's average customer has an adjusted gross income that's lower than the $42,000 national average, a segment of the market that's typically not profitable for brokers. Ernst says he's targeting the four million customers with average adjusted gross incomes of $70,000. But as the unit's steep losses show, he hasn't been able to gather nearly enough assets to offset costs. In fact, total assets under management have fallen more than 30% in the past five years, to $28 billion. "That business has continued to perform poorly and probably much more poorly than we should accept," Ernst says. He and his team are reevaluating the unit and will announce a new plan for it in June. He won't rule out a sale.

And don't count on Block's mortgage division to come to the company's rescue. In 1997, Block's previous CEO, Frank Salizzoni, purchased Option One Mortgage, which lends money to risky, or "subprime," customers. It was an extremely well-timed move, as falling interest rates would soon ignite the housing boom. The mortgage unit became Block's most profitable segment in fiscal 2003, contributing an incredible 70% of total pretax income.

But mortgage activity has dropped sharply ever since the Federal Reserve began hiking interest rates last June--and Block's earnings are now tumbling. In its latest quarter, the mortgage division's pretax income fell 28% from the previous year, to $112 million. Ernst is furiously trying to cut costs, but even Block fans aren't optimistic about the unit's prospects. "Mortgage profits have clearly peaked," says longtime shareholder Henry Berghoef, co-manager of the Oakmark Select fund.

Finally, there's the mind-boggling erosion of Block's core tax business. Block lost more than a million clients from its tax offices in the past two years, a period when the number of people who paid a preparer to file their returns hit a record. It's a figure that leaves some veteran observers flabbergasted. "Find another company in the U.S. that's lost a million customers and didn't go out of business," muses Goldman Sachs analyst Michael Hodes. The only reason Block hasn't, he says, is that it has such an immense customer base.

Considering how long the wait time can be during tax season, Block's client loss shouldn't come as a surprise. More than a third of the company's tax clients waited more than 20 minutes before they were served last year, according to Block. Ernst confesses that customers sometimes must wait as long as two to three hours.

It's not surprising, then, that time-starved tax filers are increasingly seeking options. Those alternatives include tax-preparation software programs and the Internet. The trouble is, most computer users aren't going to Block but rather to Intuit's TurboTax, which has long been the standard in tax-prep software. Even though TurboTax costs 50% more than Block's TaxCut software, it has three times the market share.

Block is also facing some stiff nondigital competition from rival tax chains Jackson Hewitt Tax Service and Liberty Tax Service. Started in 1982, Jackson Hewitt is growing its return volumes some 10% to 12% a year, primarily by focusing aggressively on low-income clients. Jackson Hewitt is now the nation's No. 2 tax preparer, filling out returns for three million customers at 5,500 offices. Liberty Tax is one of the fastest-growing franchises in the country. Run by CEO John Hewitt, a former regional director at Block who also founded Jackson Hewitt before selling it in 1997, Liberty has opened 1,400 offices in the U.S. since 1998. At an average cost of $130 per return, Liberty Tax is about $10 cheaper than Block. Hewitt expects to prepare 1.3 million returns this year, double the number from just two years ago.

Ernst acknowledges the damage the rivals are doing to Block's tax business and is desperately trying to reverse the erosion. He hopes to boost retention by giving clients more customized advice. And to reduce waiting times, he's opened more than 1,000 new tax offices and hired 30,000 new tax professionals since January.

But critics say flooding the market with more offices may not solve Block's problems. Nelson Maldonado, 35, worked for 11 years overseeing 15 tax offices as a district manager at Block. He quit two years ago and jumped to Liberty Tax, where he manages four offices in Fort Myers, Fla. He says Ernst's cross-selling strategy backfired and drove away customers. "The majority of clients don't want to be told to open a brokerage account or to refinance their house," he says. "They just want their taxes done."

Ernst couldn't disagree more. He says that from Jan. 1 to mid-February this year Block's tax preparers referred more than 64,000 customers to the firm's financial advisors, matching the total referrals made in all of 2004. "That shows you the scale we have," he adds.

As for profits, he concedes they have eluded him in the financial-advisors unit. Still, he insists, he's made "major progress" in fulfilling his promise to turn Block into a full-fledged financial firm. It just takes time. Says Ernst: "Organizations as large as ours don't change overnight."

Overnight, no. But after four years shareholders should see results. If not, they have every right to call for an audit.