Description

We recommend purchasing shares in Avantax (AVTA). Following the recently completed divestiture of TaxAct (closed on 12/19/22), Avantax has an under-levered balance sheet and management has committed to returning significant capital to shareholders. Additionally, the rapid rise in the Fed Funds rate combined with recent market strength means management’s previous outlook for 2023 earnings possibilities should be exceeded at the high end. Finally, as a company now operating with one segment, the probability of a sale of the remaining business has likely increased.

Current Capital Structure

Avantax is in the middle of executing a tender offer for $250 million of stock between $27 - $31 a share. Assuming it gets done at $30, that will take out 8.3 million shares. Pro-forma share-count would be 40.7 million before any additional capital return, and based on 2023 FCF expectations the company would end the year debt free.

How Avantax makes money

Through its original purchase of HD Vest in 2015, Avantax is a pioneer in the business of having your tax professional also assist you with tax-smart wealth management advice. This business dates back to the 1980s. The concept was simple: your accountant knows your full financial picture, and therefore theoretically should be able to provide you with services similar to a traditional financial advisor, but in a more tax-advantaged way to suit your specific financial situation.

Avantax today operates as a network of accountants and tax professionals who collectively oversee brokerage + advisory assets of approximately $75-80 billion. Revenue is generated primarily in the following ways:

• Advisory revenues are asset-based fees charged to clients where Avantax is the RIA
  • Roughly 1% on advisory assets approaching $40b
• Commission revenues (transaction-based as well as trailing) on brokerage assets also approaching $40b
• Asset-based revenues, which now will primarily be driven by cash sweep income earned on client cash

Avantax pays out on average roughly 75% of the advisory and commission-based revenues to its network of tax professionals with a fairly wide dispersion (higher producing accounts get a higher payout ratio). However, Avantax retains for itself the majority of the income generated from cash sweep programs.

Revenue growth is driven by the following factors:

• Net new assets on the platform from both existing clients as well as adding more advisors
• Market performance driving higher asset levels
• Shifting existing assets from brokerage based assets to advisory (advisory assets at 1% vs. commissions on brokerage assets typically being far lower as a % of total assets)

2023 Earnings Expectations & Valuation

At its June 2021 Investor Day, management outlined the opportunity for incremental earnings from cash sweep. Remember, this was during a time where Fed Funds was effectively -0-, so expectations were modest. Management said that if the Fed Funds rate was to increase to between 1.25-1.50%, there was an opportunity for incremental asset-based revenues of $40-55 million. This was updated in early 2022, where management said if Fed Funds was to be between 2.25-2.50% then sweep income would be between $73-82 million.

On its Q3 2022 call management gave its latest update. Assuming a 4% Fed Funds rate at year-end along with S&P at 3,000 then segment EBITDA would be $135m, whereas at S&P 4,250 segment income would be north of $170 million. With the S&P 500 today sitting at 4,100+ and with Fed Funds now at 4.5%-4.75%, our bias is to take the high-end of this range.

Assuming $175 million of segment income and $25 million of corporate expense, we arrive at consolidated EBITDA of $150 million. On an un-levered basis this should generate $100+ million of Net Income / FCF.

Pro-forma for the tender offer at $30 as well as factoring in FCF expectations for 2023, we get to a debt-free balance sheet at year-end with 41 million shares outstanding, which equates to FCF/share of around $2.50, EPS higher than that.

It’s worth noting the distinction we made earlier regarding segment income vs. consolidated income. Historically, Avantax (formerly Blucora, and before that InfoSpace) was a collection of businesses, each with its own full set of management teams. Following the sale of TaxAct, the Avantax “segment” still runs with its own leadership, but there still exists the layer of “corporate” which costs $25-$30 million annually. We believe it’s possible this expense can be reduced substantially by a strategic acquirer, and perhaps by a financial one as well.

• Valuing consolidated EBITDA at 10x leads to a $1.5 billion valuation.
• Valuing segment EBITDA of $175m at 8x leads to a $1.4b valuation.
• Using mid-point of $1.45 billion on 41 million shares outstanding yields a value of $35+, which is still substantial upside vs. where shares are trading right now.

From a P/E perspective, a $35 share price on $2.50 of earnings power is only 14x, and that’s on an un-levered balance sheet at year-end. Doesn’t feel like a particularly offensive multiple to us.

It’s worth noting, management has committed to an additional $200m of capital return following the tender offer, or almost $5 per share, which can be via some combination of buyback as well as perhaps a special dividend.

Summary

Clean balance sheet, simplified business, substantial capital return to shareholders, and the opportunity for an acquirer to realize a large amount of cost synergies upfront (not to mention revenue synergies from a true strategic) – it feels like today at 12x un-levered FCF there still exists substantial upside to shares even after the recent run-up.

Catalyst

• Significant capital return continues (additional $200 million authorized for share repurhase following completion of current tender offer)
• Potential for sale of remaining business considering under-levered balance sheet and rumors of prior approaches from potential acquirers