Description

HRB is the largest tax prep services company in the US.  New management came in a few years back after four CEOs in six years and attempted to refocus the company as a steady/defensive business by cutting costs, shedding non-core assets including the bank to free up capital and embarking on a significant capital deployment program.  There was also hope that ACA would be a big tailwind for HRB given its increased complexity.  These themes constituted a decent and popular bull pitch but this is largely all behind the company now.  HRB is now a short.  The bank was sold and capital was aggressively redeployed into share repurchases (poorly timed of course so far though $1.2B remains authorized through June 2019) and mgmt has recently changed yet again.  In a low volume growth at best business, there is cost pressure, pricing pressure, continued market share losses to INTU and local CPAs, growing technological replacement risk, new mgmt risk and emerging tax code simplification headwinds which will lead HRB stock lower.  Further, HRB garners most of its cash profits from the Assisted side of its business and there is a secular shift to DIY (50-100bps per year) that should gain steam. 

HRB provides assisted income tax return preparation, digital DIY tax solutions and other services and products related to income tax return preparation to the general public primarily in the US, Canada and Australia.  In fiscal 2017, HRB prepared 23.0MM tax returns worldwide (which was down from 23.1MM in 2016 and 24.1MM in 2015) through 12K company-owned and franchised retail tax offices and through H&R Block digital do-it-yourself products.  All US tax returns prepared by HRB during the 2017 tax season (including those prepared by franchisees and DIY solutions) comprised ~14% of an IRS estimate of total individual income tax returns filed.  Other services and products include Refund Transfers, Emerald Advance Lines of Credit, Prepaid Mastercards, Peace of Mind Extended Service Plan, Tax Identity Shield Protection Products, Refund Advance Loans and Instant Cash Back offerings.  HRB competes with local CPAs and Jackson/Liberty on the assisted side and Intuit Turbo Tax, Tax Act, Credit Karma and other digital players on the DIY side.  As you would expect, the company is highly seasonal with its fiscal Q4 as make or break.

Thesis

1)     Volumes at the IRS are expected to be +100bps this year.  HRB management expects the assisted channel to be flat while the digital channel should be up 400bps.  This isn’t exciting.

2)     Cost cuts helped fiscal 2017 but are unlikely to be used again.  Various mgmt teams have cut costs for the past handful of years and aggressively in fiscal 2017.  On the Q1 call, mgmt signaled a headwind on costs.  Seemingly, the games have run out here. 

3)     Intuit, Credit Karma (who launched a free online tax prep platform in late 2016), local CPAs and Jackson/Liberty are all planning to be aggressive competitors.  Intuit has stated its intention to ramp up TurboTax volumes and its SmartLook offering links customers and tax professionals to see their computer screens and solve problems real time.  Competition is heating up. 

4)     In the past 10 years, HRB’s assisted market share has gone from 24% to 16% and mgmt has offset that volume decline by raising price.  This strategy has worked well until last year where revenue and EBIT were down and thus the stock was hit hard.  Mgmt responded this most recent fiscal year by cutting expenses and buying in some franchises (which made revenue look less bad) and the stock rebounded only to come in a bit of late.  Market share losses will continue as the product isn’t as good as Intuit’s and there is just too much competition from a growing cast of characters.

5)     At some point, there should be an easier way to deal with ones taxes.  Phone technology and image capturing is helping to accelerate the risk here.  Technological replacement risk is a real threat.

6)     The new CEO starts October 9^th and he was the CMO of Target and President of Ride Sharing at Uber before coming to HRB.  I heard the Board liked his marketing chops.  Last year, expense savings in marketing helped drive EBIT and I think its reasonable to expect more marketing $ spent out of HRB this year as continued market share losses and declines in assisted returns are not sustainable.

7)     There has always been political talk of simplifying the tax code but now there does seem to be some momentum for change here.  Northcoast Research noted that “experts suggest that the new plan will cut the number of tax brackets to three while doubling the standard deduction and eliminating all itemized deductions with the exception of home loan interest, retirement savings and charitable contributions”.  Obviously, the need for HRB/Assisted services is greatly diminished by a less complex tax code.  FWIW, Northcoast noted a scenario today where 4-18 cents could be taken out of earnings (which seems light to me considering this really impacts their most profitable customers) and I think the multiple would get hit materially in that scenario.  I already think consensus for this year is roughly 10-15% too high given the dynamics I mentioned above.  That said, corporate tax reform could be a positive and largely offset the simplification of the tax code negative.  Hard to say how it plays out but I think its pretty obvious the tax code is too complex and that earlier this year Trump singled out HRB as the one company that would be unhappy with his tax reform plans.  He says a lot of things though.

8)     The share shift to DIY yourself has continued year after year.  This trend will continue and it’s a real problem for HRB because Assisted returns are higher cash flows for the company.  HRB’s profits are largely from Assisted so every $ that goes into DIY (even if they capture it despite a lower digital share) weighs.

I think there is 20-40% downside from here.  Basically, I believe pricing will come under greater pressure this year as competition accelerates and the cost levers are gone – consensus numbers are too high and there is substantial risk from a tax code simplification.  This seems to be a slowly dying business with some real risks and should trade at 10-12x my estimate. 

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

Catalyst

Earnings disappointment

Tax code changes