Has the Tax Preparation Industry Lost Its Luster?
In reviewing the overall top 50 Magic Formula stocks from the official screen recently, it struck me as interesting that the two largest tax preparation firms in the U.S., Jackson-Hewitt (JTX) and H&R Block (HRB), both had made the list. While Jackson-Hewitt has long been in and out of the Magic Formula screens due to operational issues, H&R Block was a new addition, and this old-line tax prep firm had just gotten beat down 22% over a 3-week time span, one of its worst drops in 25 years.
Could it be that there are some fundamental changes in the office-based tax preparation industry that are causing these traditional powerhouses to suffer? Or are we looking at short-term concerns that may indicate that these two stocks could be attractive investments? Let's take a look at what is going on in the industry and try to come to a conclusion on those questions.
The Tax Prep Industry - Historically an Attractive Business
In the United States, virtually all working American households must file a tax return with the Internal Revenue Service (IRS). Roughly 130 million returns were filed in 2008. The tax code is highly complex, with numerous rules, restrictions, deductions, credits, variable tax rates, and so forth. In fact, for 2009, the official tax code is an absurd 67,000 pages long!
With this kind of complexity, many filers look for professional help. According to the IRS, about 61% of filers utilize a paid preparation service. The industry is extremely fragmented, with between 900,000 and 1.2 million preparers nationwide, spanning from the large national firms to small "mom-and-pop" accounting offices. H&R Block is by far the largest, filing over 21 million returns in 2008, about 16% of the total. The next largest is Jackson-Hewitt with about 3 million returns, or roughly 2.3% share.
There are several factors that make office-based tax preparation an attractive business, historically. First, of course, is the inevitability - practically everyone has to file a tax return, every year. This creates a stable stream of revenues for the preparers, largely sheltering them from the ups and downs of the overall economic environment. Second is that the business is very low capital. There are no factories to build, no inventory to finance and warehouse, etc. The franchise model used by both firms reduces capital investment even more. Strong brands are an important intangible asset that created customer loyalty form year to year.
These advantages show up in the numbers. H&R Block has historically run operating margins in the mid-20% range, with returns on equity at 35-40%. Jackson-Hewitt did even better, with operating margins averaging 36% between 2003 and 2007.
Technology Strikes Again
The biggest change in recent years for tax preparers has been that familiar harbinger of death for many industries: technological change. PC-based tax preparation software such as Intuit's (INTU) TurboTax, combined with electronic filing options from the IRS, has begun really hurting traditional preparers - and this trend is accelerating. Returns filed electronically have grown at a compounded 18% annually over the past 6 years. Last year, over 31 million returns were filed in this manner, 24% of the total.
This is bad news for both Block and Jackson-Hewitt. Jackson-Hewitt does not have a software product, so they lose revenue with every former customer that decides to go the "do-it-yourself" (DIY) route. H&R Block does have a product (known as "H&R Block At Home", formerly TaxCut), but it has fared poorly against TurboTax. In fact, so far in the 2010 filing season Intuit has reported 11% unit sales growth of TurboTax while Block has shown a 4.4% decline in sales of At Home.
Finally, these software products lower the perceived value of office-based tax prep. For example, while filers at H&R Block's offices generally pay around $200, At Home can be purchased for around $40, and can handle the vast majority of filer's needs.
Frowning Upon RALs
Refund anticipation loans, or RALs, have been a catalyst behind increased performance for both HRB and JTX in the early portions of the past decade. These are short-term loans to customers, enabling them to get immediate cash which is then paid back when the IRS delivers the tax refund. For the tax preparers, the juicy part of the deal are the 50-300% annual interest rates on them. If a customer does not immediately pay off the loan, big interest charges funnel directly into the company's (and lending bank's) coffers.
RALs have been targeted by consumer groups as predatory, and the government frowns upon them, although they are legal. At any time, legislation could be introduced that limits the practice. As it is, few banks are interested in funding them, and any bank that received federal "bailout" money in 2008-09 are forbidden from offering them. This really cost Jackson-Hewitt this year, as they lost 50% of their funding, and RALs are a major part of their business (~22% of revenue, vs. Block's 4%). H&R Block is in better shape, holding an agreement with HSBC through 2011.
The uncertainty around regulations and difficulty in securing funding for RALs is yet another hit against our two Magic Formula stocks.
Help from the IRS?
One potential positive for these two firms going forward is coming from an unlikely place: the IRS itself. Back in January, the agency announced a plan to regulate the industry, requiring tax preparers to register, pass a competency test, and pay a fee, in an effort to weed out fraud and incompetent advisors. In effect a license, it will have to be renewed every 3 years.
This is a positive because it will push out some of the smaller "fly-by-night" tax prep firms that seem to pop up in strip malls all over the country. The IRS has already sent out over 10,000 notices to firms that have displayed consistent issues with returns. Less competition, especially of the bargain variety, is a good thing.
Finally, back to the original question: is the office-based tax prep industry becoming increasingly less attractive for the long-term, or are we looking at short-term issues that will reverse themselves in time? I believe clearly that it is the former. PC-based online tax filing is here to stay and continues to take significant market share. H&R Block is having serious trouble competing with Intuit. Intuit has two big advantages here. One is that TurboTax is well-established, trusted, and had a large base of users before Block even entered the game. Second is that Intuit also makes the popular QuickBooks and Quicken programs, creating a funnel directly into TurboTax. Jackson-Hewitt is way, way behind, although they have announced intentions to provide a PC product of their own.
The poor perception of RALs and increasing new office-based competition fill out the bleak picture. So far this season, Block has reported a 9.4% decline in return volumes, and Jackson-Hewitt a horrid 18% decline. Besieged by competitive, regulatory, and technological challenges, these look like two MFI stocks to stay away from.