True to Form

Ask the average rep to free associate on the name “H&R Block,” and one word would appear in virtually all the responses: taxes. Block has been a fixture in the tax-preparation business for so long that its name is synonymous with tax season.

But that strong brand identity has a downside: It has pigeonholed the firm and hampered its efforts to become a serious player in the financial advisory business. When one Highland, Mich.-based financial planner recently looked into Block's tax-preparation course, for instance, he was surprised at the company's focus on investments. Only after asking around did he learn that Block offers mortgages, brokerage and investment advice through its H&R Block Financial Advisors division.

Block spokesman Dan Grubbs explains the thinking behind the expanded offerings: “When you can provide a one-stop shop with a team of professionals that includes a tax advisor, a financial advisor and a mortgage loan officer, that makes for a pretty winning combination not found anywhere else.”

This makes perfect sense in theory, but is it working in practice? Yes and no. On the positive side, Block gathered more profits from its mortgage business ($678 million) than its tax-prep business in 2004, so there is evidence that diversification can work. It's just not doing so in the advisory business so far. Block Financial Advisors has been losing money since 2001, and its former president and CEO Brian Nygaard left in January (for personal reasons), following a December 2004 censure and a fine by the NASD for issues relating to market-timing in mutual funds.

Even before this upheaval, Morgan Stanley analysts said in research reports, “Don't expect the business to turn profitable before late 2006.” While undertaking a search for Nygaard's successor, Block CEO Mark Ernst has said he hopes to see this business make a dramatic turnaround within a year.

Worth the Effort?

H&R Block's origins date to the 1950s, when it was founded as a bookkeeping company by the brothers Henry and Richard Bloch. It is only in the last decade or so that the firm has gotten serious about moving beyond those roots. In 1999, it purchased Olde Discount Brokerage with the intent of transforming it into a full-service advisory company. Then, in 2000, it unveiled a long menu of financial services. Over the last couple of years, it has worked on building and improving the infrastructure — systems and processes — required to make a serious go of the advisory business.

All of these efforts are aimed at the same thing: turning the firm's once-a-year domination of a financial event (tax season) into a more extensive, and profitable, endeavor. Block found that if, after processing customers' IRS refunds, it also told them where to invest it and how to manage those investments, many were willing to stick around. In some ways, Kansas City, Mo.-based Block is hoping to accomplish what commercial banks like Wachovia and Bank of America have, using its primary business as a referral machine. In Block's case, the pool of referable customers is quite large. It has close to 17 million tax-preparation customers.

It's true that many — or maybe even most — of these customers reside at an income level that wirehouse advisors would consider beneath them. That precisely is the point. Block's strategy hinges on offering services to the underserved middle-American market. Its dealings with “average Americans” convinced Block that its tax-preparation clients tend to be wanting for advisory and other financial services.

“There's really a disconnect between today's investor and the way brokerage operations are set up,” explains Tom Watson, a wealth management analyst at Forrester Research. “That leaves a lot of space for innovative ways to approach the financial advice market.”

Forrester's consumer research reveals that more and more investors are becoming “validators” — a group that likes to keep control of their finances, but also wants advice from professionals. “H&R Block recognizes that there is room out there for a new type of advice, catering to a customer who is younger and less wealthy than the ‘delegator’, someone who may not get the attention of an advisor at Merrill Lynch,” Watson says. “Even the regional brokerages target the higher-asset individual — the over $250,000K household.”

Reality Bites

There's a specific reason why this underadvised market exists: Few of these mainstream investors generate much income for their advisors or their firms. At the same time, because they are unsophisticated in the ways of complex financial matters, they often need extra hand-holding. “The person they're selling their tax product to is not the most profitable wealth management client,” says one analyst.

Adds Watson: “The mainstream consumer who uses H&R for taxes is in need of some planning and is willing to escalate that relationship.” Unfortunately, “it's hard to do this profitably for someone with less than $100K.”

Block executives acknowledge this dilemma, but add that the firm is having some success in making these sorts of customers profitable. “It is possible to serve these clients profitably, but it depends on how you do it,” says Jeff Yabuki, executive vice president and chief operating officer for H&R Block. He says that Block's target client is one who historically does not generate much income for traditional brokerage firms, because the cost of serving and acquiring the client was too high. “At Block, we have a different model,” he says. “We make our money serving their tax needs. So we need to transfer those clients over to qualified financial planning professionals, and that ameliorates the acquisition cost.”

He adds, “So far the process has been slow — slower than I'd like it to be. But we're making progress.” This year has been better than last, already, Yabuki says. Block has acquired 64,000 new investment clients through the end of February.

Still, Block has its work cut out for it. The glut of advisory services has created intense competition for profit-generating clients, which in turn has given rise to a sense of entitlement in the $100,000-and-over class of investors. Typically these clients demand special attention — a little luxury, if you will — from their financial planners. They want the guy sitting with the couple on the beach in the commercials, unrealistic as that scenario might be.

And H&R Block is not that sort of firm — at least not yet. “It's tough for them to compete against better branded companies like Schwab and TD Waterhouse,” says one analyst.

The secret to competing against big-name advisory firms is to attract top talent — but that is an expensive proposition.

Still, it's not hopeless. Revenues streams at Block have begun shifting in a promising way. Only 52 percent of Block's revenue now hails from the tax division; the rest from mortgage and financial services. And at least one analyst is thinking good thoughts: Alexander Paris, director of research at Chicago-based Barrington Research, expects the Financial Advisors division to perform better as both the economy and the stock market improve.

“The constraint is not the demand side — and it's not the process or technology, necessarily,” Watson says. “The constraint is talent.” However, Watson suggests that getting experienced professionals to come on board is not going to be easy, given that the company is approaching the less affluent market. “It will be challenging for them to afford the top talent out there and yet serve a more mainstream client base,” he says.

Talent Scouting

Still, Block is trying hard to attract advisors. It currently employs more than 1,000, and it is adding new ones at a rate of about 20 per month. About half of H&R Block's current financial advisors are Olde holdovers, and the other half have been recruited.

A typical recruit has production of above $350,000, is relatively young (with one to five years experience) and is possibly being pressured by his wirehouse employer to dramatically increase production. Payouts are typical, ranging from 30 percent to 50 percent, based on an advisor's experience and on the book of business he might bring with him.

Part of the recruiting come-on is that Block's tax-prep business delivers “warm” prospects, and this resonates with many of the firm's employees. For instance, Matthew Winthrop, an H&R Block financial advisor in Greenwich, Conn., came of age professionally in NYC wirehouses, but he is positively gleeful about the all the ready-made leads falling into his lap via his tax-pro colleagues.

“I never had anything like this,” he says. No more cold calling. No more hitting the phone book or dragging oneself to trade shows. Instead, a tax pro will call him and say something like, “Hey Matt! Mr. and Mrs. Johnson just sold their house, and have come into a substantial amount of money. They don't have a relationship with a financial advisor. Can we set up an appointment?”

“The tax pro already has a good relationship with the client,” says Winthrop. “So they feel a little warm and fuzzy because we're all with the same firm.” Others echo his enthusiasm. “The brand gets my foot in the door every time and makes a prospective client much less confrontational,” says Nathan Foret, who works in the Mobile, Ala., area.

Can they leverage that enough so clients won't mind more mass-produced (and less expensive) attention? Can they differentiate themselves in other ways from their nearest competitors, such as ING Financial Horizons? Or can they start bringing in talent to attract bigger dollars? These are some of the questions Ernst and the incoming president of the financial advisory division will have to answer if a turnaround is to come.