Block Financial’s strategic changes are credit negative

Last Tuesday, H&R Block Inc., which issues debt through its wholly owned subsidiary Block Financial LLC
(Baa3 negative), said it plans to change its pricing structure, close about 400 of its nearly 10,000 US offices
and commence a large, multi-year investment program to update its information technology capabilities.

We view these strategic changes as credit negative because they risk triggering a response from competitors
or other unanticipated consequences that will result in steeper, or longer-lasting, declines in revenue and
profit. Following the announcement, we affirmed Block’s ratings and changed its outlook to negative
from stable.

Block disclosed its plans in conjunction with its earnings release for its fiscal fourth-quarter, which ended 30
April 2018. The company warned that it expects fiscal 2019 revenue to decline by as much as 3% and that
EBITDA margins (as defined by the company) will contract by more than 350 basis points versus 2018.

Improved financial results for the 2018 tax season and a onetime approximately $150 million cash flow
benefit from the 2017 Tax and Jobs Act gave Block a strong liquidity position from which to initiate its
planned strategy changes and investments. However, there is a material risk that the company will be
unable to reverse the revenue and margin erosion expected in 2019, which would lead to elevated financial
leverage, diminished free cash flow and a weakened competitive position. We would consider returning
Block’s rating outlook to stable if we expect customer and revenue growth in fiscal 2020, along with
improving profitability and steady financial policies.

Block’s financial strength is constrained by the competitive nature of the tax preparation industry. The
market is characterized by extremely seasonal revenue and cash flow, as well as a gradual shift among
consumers to do-it-yourself tax filing solutions, a segment of the market in which Block faces significant
competition from Intuit Inc.’s (A3 stable) TurboTax franchise. Block still generates most of its profits and
free cash flow from assisted tax filing services.