Description

H&R Block Introduction:

HRB provides tax preparation services to consumers at company-owned stores (“Assisted”), franchisee-owned stores (“Royalty”) and online (“DIY”). The majority of HRB revenue comes from the Assisted segment, which are revenues generated by consumers that file their taxes at company-owned and franchisee HRB locations. Over the past seven years, HRB has been unable to grow Assisted Volumes and have offset volume declines with price increases.

In October 2017, HRB hired Jeff Jones who was formerly the President of Uber Ride Share and CMO of Target. HRB believed that his strong marketing background would enable him to curb Assisted volume declines. A few months later during the June 2018 Earnings call, Jeff acknowledged that HRB had become too reliant on price to grow revenues and announced a pricing reset within the Assisted business to improve HRB’s value proposition. Despite the 2019 tax season Assisted price reset of (4.3%), Company-Owned Assisted Volumes declined (20) bps YoY and EBITDA margins declined ~(400)bps YoY. The YoY decline in margins illustrates how HRB generates significantly higher EBITDA from their Assisted tax store business (but is not specifically disclosed by the company).

For the 2020 tax season, HRB guidance implies organic growth guidance of 0.2% - 2.0% which will be difficult to achieve given continued volume declines within Assisted (~68% of FY19 Revenue). There have also been recent developments with the Free File Alliance, an Agreement between the IRS and tax software companies, that will likely limit long-term DIY revenue growth (~8% of FY19 Revenue). EBITDA margins will also continue to be pressured by acquisition of Wave, which provides payment, payroll and bookkeeping services to small and medium-sized businesses.  While HRB expects to cross-sell core tax preparation services to Wave customers, management expects Wave to generate $25 – 30m of operating losses this fiscal year and for it to remain unprofitable in the “near to medium term”. The sell-side expects ~2% total revenue growth and ~20bps of margin expansion, which should reset lower after HRB reports results for the full 2020 Tax Season in June.

Key Thesis Points:

• HRB will continue to show negative Assisted Growth (~68% of Revenue) in the 2020 tax season due to (1) the long-term secular mix-shift from Assisted to DIY accelerated by INTU’s continued investment in Turbo Tax, (2) tax code changes that require ~20% fewer filers to itemize deductions (3) lack of lower pricing initiatives to help drive traffic to stores & (4) increased price transparency which may lead consumers to seek cheaper alternatives.
• HRB DIY Volumes (~8% of Revenue) also face (1) increased marketing spend from INTU, (2) new hybrid Assisted-DIY products that will cannibalize Assisted volumes and (3) potential for the IRS to enter the tax software market due to deceptive marketing practices by both INTU & HRB.

   

Source: HRB Company Filings

Core HRB Assisted (Tax Store) business will continue to face secular headwinds

~68%% of HRB revenue comes from the US Assisted segment (primarily company-owned stores). Assisted volumes continue to face secular headwinds, illustrated by the fact that HRB has not been able to grow Assisted volumes for over seven years as more American filers shift to DIY solutions.

The chart from the most recent INTU Investor Day below best outlines this secular headwind. Over the last ten years, the US Tax Market (volume reported by the IRS) has grown at an annual rate of 0.8%, while Assisted Volumes (“Tax Stores”) have declined at a rate of (2.5%). TurboTax volumes have grown at an annual rate of 5.6% and “Other DIY” (which includes HRB DIY volumes) have grown at 2.0%. Despite the negative secular growth of (2.5%) shown by historical Assisted (“Tax Store”) volumes over the past ten years, HRB still expects the Assisted tax market to be “flat to slightly up” for the 2020 tax season.

Source: HRB FY 2Q 20 Earnings Call (12.04.2019) 

Source: Intuit 2019 Investor Day (October 03, 2019)

We are also entering the second year post-tax reform. The new tax plan doubled the standard deduction, which reduces the number of people that need to itemize from 26.3% to 7.6% of total tax filers. Assisted filers that no longer need to itemize are more likely to shift to lower priced DIY software and consequently accelerate the secular shift from Assisted to DIY.

Source: https://www.whitehouse.gov/sites/whitehouse.gov/files/images/Effects%20of%20Changes%20to%20the%20Mortgage%20Interest%20Deduction%20FINAL.pdf

Competitive environment and pricing transparency will make it difficult to offset Assisted volume declines with price

Despite a pricing reset during the FY19 tax season, HRB Company-Owned Assisted volumes still declined (20) bps. The pricing reset effectively lowered the Net Average Charge (i.e. Average Revenue per Tax Return filed) to levels seen in FY16, further outlining the high premium that HRB charged versus competitors.

Probably most incremental is the HRB transparent pricing initiative. HRB Assisted customers can now walk into a store and look at a pricing sheet to determine how much it will cost to file their taxes. While the program has only been in place for one year, HRB management claims the strategy will help improve customer retention and satisfaction. But transparent pricing will also make it easier for customers to shop different Assisted competitors and highlight the stark discount of DIY offerings. Most importantly, it will make it more difficult for HRB to use price as a lever to offset lower volumes in future years.

While the sell-side does not specifically break out their assumptions for the Assisted segment, we estimate that consensus expects a slight increase to Assisted revenues (implying that HRB maintains share in a market that is “flat to slightly up”), which seems unlikely given that HRB has been unable to grow volumes in over seven years. HRB management has also made it clear that they will not lower price for the 2020 tax season, which means that Assisted volumes will not benefit from additional price decreases to help curb volume declines.

Source: HRB FY 2Q 20 Earnings Call (12.04.2019)

Source: HRB Company Filings

Intuit’s increased marketing budget aims to “transform the assisted category” with Hybrid Assisted / DIY products

INTU launched TurboTax Live, a hybrid-DIY / Assisted product, at the start of the 2018 tax season. The product essentially allows customers to upload their tax documents and have a tax preparer complete and sign the return, eliminating the need to visit a physical tax store. In response, HRB launched a similar competitive offering called Ask a Tax Pro Go. Our view is that HRB hybrid products will be less incremental to volume growth than expected, because they should cannibalize in-store Assisted filers that prefer an easier online experience at a lower price point.

INTU has also made it clear that they plan to target the Assisted Market with Turbo Tax Live. On the Q1 2020 Earnings Call, Intuit missed sell-side EPS estimates due to higher incremental marketing spend to “raise awareness to transform the assisted category.” It appears that INTU planned to increase marketing for DIY tax products by >$40m. Continued investment and marketing by INTU should further encourage the shift to DIY products and make it difficult for HRB to retain market share unless they respond in-kind.  

Source: INTU FY 1Q 20 Earnings Call (11.21.2019)

Material revisions to the Free File Alliance Program:

The Free File Alliance (FFA) is an agreement between HRB, INTU and other tax software providers agreeing to offer free tax preparation services to lower income Americans. In exchange, the IRS would not develop their own tax software.

In October 2019, both HRB & INTU were scrutinized for deliberately blocking Google search results from displaying the Free File Program and making the truly free products more difficult to find.

Source: https://www.propublica.org/article/turbotax-deliberately-hides-its-free-file-page-from-search-engines

As a result, the IRS released a new memo at the end of December 2019 that (1) prohibited members of the Alliance from removing the Free File products from organic internet search, (2) standardized naming conventions to “IRS Free File program delivered by (Company Name)”, (3) implemented random customer surveys to track filer satisfaction, (4) mandated audits from an independent third party twice a year; all in addition to other amendments aimed at driving adoption and compliance of the Free File Program.

The most detrimental measure was the removal of the clause that states, “In recognition of this commitment, the federal government has pledged not to enter the tax return software and e-file services market place.” If the Federal government were to develop their own tax software, they would become a direct publicly-funded competitor to INTU and HRB. While it would take a few years for the Federal Government to develop their own tax software, it would make it even more difficult for HRB to compete within the DIY segment.

Source: https://www.irs.gov/pub/irs-utl/FFI%20Signed%20MOU%20Addendum%2012-26-19.pdf

During the most recent INTU earnings call, Intuit disclosed that the IRS estimates 104m Americans are eligible for Free File but only 20m Americans are filing their taxes for free. While it is difficult to say how much of an impact this will have on total HRB DIY volumes, we expect that more Americans will become aware of the Free File Alliance and shift to the free software.

Source: INTU FY 1Q 20 Earnings Call (11.21.2019)

If we assume that 10 million Americans (out of the additional 84 million tax filers eligible for Free File) file their taxes for free during the 2020 tax season, it would result in a >$50m organic growth headwind to FY20E revenues based on HRB’s current market share and Net Average Charge. The headwind could get worse in future years, with an additional 74 million Americans eligible to file their taxes for free.

Conclusion:

HRB management believes that they will be able to grow organic revenues in the LSD range, while keeping EBITDA margins in the 24 – 26% range, despite secular headwinds to higher margin Assisted volumes and incremental operating losses from recent acquisition Wave.

It seems more likely that Assisted volumes will continue to decline, as structural changes to the US tax code accelerate the shift to DIY, the pricing lever to drive store traffic is limited and the larger INTU marketing budget transforms the Assisted category. Current sell-side estimates for MSD growth within the HRB DIY business may be at risk from the Free File Agreement and the competitive environment.

HRB will be unable to expand EBITDA margins in the face of negative assisted volumes combined with flat pricing and $25 – 30m incremental operating losses from the Wave acquisition (that HRB plans to offset via cost reductions). HRB will also likely have to ramp up marketing spend in order to better compete with INTU’s larger marketing budget, or consequently lose Assisted customers to the newer Hybrid Assisted-DIY products.

Catalysts:

• FY4Q June Earnings Release (with results of 2020 Tax Season)
• IRS develops their own tax software

Risks:

• HRB cost reductions are enough to offset margin dilution

• Changes to the Tax Code from a new President in 2021, which creates confusion among filers and creates demand for tax professionalsHRB DIY Market Share gains are enough to offset
• Changes to the Tax Code from a new President in 2021, which creates confusion among filers and creates demand for tax professionalsHRB DIY Market Share gains are enough to offset HRB Assisted Revenue headwinds

Disclaimer:

The views and opinions stated are the personal views of the author. Do not rely on the information set forth in this write-up as the basis upon which you make an investment decision – please do your own work. The author and funds managed by the author hold positions in and trade, from time to time, securities issued by HRB and options on such securities. This write-up does not purport to be complete on the topics addressed, and the author takes no responsibility to update this write-up in the future. This is not a recommendation to buy or sell any securities.

Catalyst

Catalysts:

• FY4Q June Earnings Release (with results of 2020 Tax Season)
• IRS develops their own tax software