OAKMARK FUNDS'
BILL NYGREN & HENRY BERGHOEF

(continued from preceding page)

Block's business is awesome today and very improvable.

Berghoef: We're much more focused on the fundamental business. And at H&R Block - whew! - that tax business is just a terrific business. It's growing very rapidly, has very high margins and very high market share and no competition, really. The competition is basically people doing it themselves.

And as well as that tax business has done over the years, we think it can do a lot better. A new management team came in - what was it? - three years ago. And they're starting to apply the kinds of management techniques to this company that never had been applied before - like demand-based pricing (charging more during peak periods).

And they're trying to take Block a little more upscale. The average income of a Block client is very, very low - I believe something like $35,000. So if they could move the average income up to $50,000 or something like that, it would be tremendously meaningful for them.

The other thing they have: Like a lot of businesses, the people that come into their door de novo - new clients - have a very high churn rate. People that stay with them for three years are likely to stay with them for many years. And those are very valuable clients. However, new clients have a very high churn rate.

Well, they're focusing on that now. And if they can reduce that churn rate just by a percentage point or two, it's going to be very meaningful to the bottom line for them.

Even when Block's earnings decline, its value will grow….

Berghoef: And there's another controversy at Block that fits in with what we've been saying about trying to look at things in a common sense way. They have a wholesale mortgage business that because of the refinancing boom has been just going like gangbusters. This year, the earnings in the mortgage business could approach the earnings in the tax business. And the market's very worried about that right now.

The way we look at it, while the mortgage earnings are approaching the tax earnings, the value in the company that's generated by the tax business is much, much higher than the value that's generated by the mortgage business.

At some point, the mortgage business [may] decline…. So it's not inconceivable that they might have a reduction in EPS. However, you're likely to see, even in that case, a continuing increase in the per share value of the stock. And the reason for that, to use round numbers, is we value the tax earnings at let's say 18 times. We value the mortgage earnings at let's say 5 times. So they're simply not as valuable as the tax earnings.

Nygren: Both of those are pretax, incidentally.

Berghoef: That's right. Mortgage might even be worth a little bit less than that. So what you're going to have happen is a fairly significant decline in earnings that are worth 5 times, and continuing strong double-digit increases in earnings that are valued at 18 times.

So the market right now seems to be saying, "Oh gee, what's going to happen to EPS?!" What we're focusing on is what's likely to happen to the per share value over time, not just what happens to the EPS.

Worries about loan losses are much ado about nothing.

Berghoef: The market's also worried about their potential exposure to loan losses. But the fact of the matter is that they sell all their loans either as whole loans or in securitizations. So their only exposure is the residuals that they have on their balance sheet. They tend to securitize their residuals as rapidly as they can.

And the value of the residuals on their balance sheet today is, ballpark, $250 million. Given 180 million shares outstanding, their total exposure on the balance sheet is about $1.50 a share. And this is a stock that's at $40.

Even if they were to have to write that whole thing off, which we don't think is likely, it's not very important - not very meaningful - for the company. So that's another point we look at differently than much of the market does where we think we're taking a common sense approach.

Tragically, in its core business, growth is "slowing" to 23%.

Nygren: That's another one where there's an example of a press report by a major daily financial newspaper that will go unnamed [laughs] that referred to growth "slowing" in the tax preparation business to, what was it? 23% or something like that…

Berghoef: Yeah, right. It was totally [ridiculous]…

Nygren: If all my companies could have growth slow to 20%, [chuckling] that would be a nice day.

The preceeding was excerpted from our 25-page feature with: Oakmark Fund's Bill Nygren & Henry Berghoef

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