H&R Block, Inc. And Light & Wonder

The Most Attractive Stocks (-6.8%) underperformed the S&P 500 (-3.9%) from May 4, 2022 through May 31, 2022 by 2.9%. The best performing large cap stock gained 5% and the best performing small cap stock was up 13%. Overall, 16 out of the 40 Most Attractive stocks outperformed the S&P 500.

The Most Dangerous Stocks (-1.8%) underperformed the S&P 500 (-3.9%) as a short portfolio from May 4, 2022 through May 31, 2022 by 2.1%. The best performing large cap short stock fell by 22%, and the best performing small cap short stock fell by 24%. Overall, 12 out of the 33 Most Dangerous stocks outperformed the S&P 500 as shorts.

The Most Attractive/Most Dangerous Model Portfolios underperformed as an equal-weighted long/short portfolio by 5.0%.

Seventeen new stocks made the Most Attractive list this month, and 22 new stocks also fell onto the Most Dangerous list.

The Most Attractive stocks have high and rising returns on invested capital (ROIC) and low price to economic book value ratios. Most Dangerous stocks have misleading earnings and long growth appreciation periods implied by their market valuations.

Most Attractive Stocks Feature for June: H&R Block, Inc.

H&R Block, Inc. (HRB) is the featured stock from June’s Most Attractive Stocks Model Portfolio.

H&R Block has grown revenue by 2% compounded annually and net operating profit after-tax (NOPAT) by 7% compounded annually over the past five years. The company’s NOPAT fell to $156 million during the COVID-19 pandemic in fiscal 2020 (FYE is 4/30) but has since recovered to $1.2 billion over the trailing twelve months (TTM). H&R Block’s NOPAT margin has increased from 15% in fiscal 2016 to 26% TTM, while invested capital turns rose from 1.0 to 1.7 over the same time. Rising NOPAT margins and invested capital turns drive the company’s return on invested capital (ROIC) from 14% in fiscal 2016 to 43% TTM.

Figure 1: Revenue & NOPAT Since Fiscal 2016

H&R Block Is Undervalued

At its current price of $36/share, HRB has a price-to-economic book value (PEBV) ratio of 0.3. This ratio means the market expects H&R Block’s NOPAT to permanently decline by 70%. This expectation seems overly pessimistic for a company that grew NOPAT by 7% compounded annually over the past five years and 4% compounded annually over the past ten years.

Even if H&R Block’s NOPAT margin falls to 15% (equal to 20-year average, compared to 26% TTM) and the company’s NOPAT declines by 1% compounded annually for the next decade, the stock is worth $57/share today – a 58% upside. See the math behind this reverse DCF scenario. Should H&R Block grow profits more in line with historical levels, the stock has even more upside.

Critical Details Found in Financial Filings by My Firm’s Robo-Analyst Technology

Below are specifics on the adjustments I make based on Robo-Analyst findings in H&R Block’s 10-Qs and 10-K:

Income Statement: I made $244 million in adjustments, with a net effect of removing $43 million in non-operating expense (1% of revenue).

Balance Sheet: I made $1.7 billion in adjustments to calculate invested capital with a net decrease of $244 million. One of the most notable adjustments was $735 million in asset write-downs. This adjustment represented 30% of reported net assets.

Valuation: I made $3.2 billion of adjustments with a net effect of decreasing shareholder value by $1.6 billion. One of the most notable adjustments to shareholder value was $805 million in excess cash. This adjustment represents 14% of H&R Block’s market cap.

Most Dangerous Stocks Feature: Light & Wonder Inc.

Light & Wonder Inc (LNW) is the featured stock from June’s Most Dangerous Stocks Model Portfolio.

Light & Wonder’s economic earnings, the true cash flows of the business, have fallen from -$76 million in 2017 to -$213 million over the TTM. The company’s NOPAT margin has fallen from 13% to 8%, while invested capital turns fell from 0.4 to 0.3 over the same time. Falling NOPAT margins and invested capital turns drive Light & Wonder’s ROIC from 5% in 2017 to 2% TTM.

Figure 2: Economic Earnings Since 2017

Light & Wonder Provides Poor Risk/Reward

Despite its poor fundamentals, Light & Wonder is priced for significant profit growth, and I believe the stock is overvalued.

To justify its current price of $56/share, Light & Wonder must improve its NOPAT margin to 17% (all-time high in 2019, compared to 8% TTM) and grow revenue by 7% compounded annually for the next decade. See the math behind this reverse DCF scenario. In this scenario, Light & Wonder grows NOPAT by 15% compounded annually over the next ten years. Given that Light & Wonder’s NOPAT has fallen 72% since 2019, I think these expectations look overly optimistic.

Even if Light & Wonder can achieve a NOPAT margin of 12% (five-year average) and grow revenue by 6% compounded annually for the next decade, the stock is worth just $8/share today – an 86% downside to the current stock price. See the math behind this reverse DCF scenario. Should Light & Wonder’s revenue grow at a slower rate, the stock has even more downside.

Each of these scenarios also assumes Light & Wonder can grow revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is unlikely but allows me to create truly best-case scenarios that demonstrate how high expectations embedded in the current valuation are.

Critical Details Found in Financial Filings by My Firm’s Robo-Analyst Technology

Below are specifics on the adjustments I make based on Robo-Analyst findings in Light & Wonder’s 10-Qs and 10-K:

Income Statement: I made $1.6 billion in adjustments, with a net effect of removing $189 million in non-operating income (9% of revenue).

Balance Sheet: I made $5.9 billion in adjustments to calculate invested capital with a net increase of $333 million. One of the most notable adjustments was $2.3 billion in net assets from discontinued operations. This adjustment represented 33% of reported net assets.

Valuation: I made $11.4 billion in adjustments, with a net decrease to shareholder value of $7.3 billion. Apart from total debt and the net assets from discontinued operations mentioned above, the most notable adjustment to shareholder value was $396 million in excess cash. This adjustment represents 7% of Light & Wonder’s market cap.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.