Jackson Hewitt (JTX) is a company for which the market has a keen understanding of the bear case: a high profile lawsuit targeting a large franchisee by the Justice Department and a subsequent IRS review of the company, discontinuation of so-called “pay-stub” early tax season loans, weak same-store-sales growth in the 2007 tax season which led to flat volumes y/y, concern that one of the company’s bank partners (i.e. the banks that provide the financial products that JTX makes available to customers for a fee) might pull its business and aggressive competitors in H&R Block and Liberty Tax. These fears have pushed JTX’s valuation to less than 13x my estimate of FY08 (April) earnings and a roughly 10% free cash flow yield.  This for a company that has a growing top line driven mostly by strong pricing power, a high ROIC business model, substantial and predictable free cash flow generation and a management team that got the memo about returning excess capital to shareholders.  In fact, since the company’s June 2004 IPO, JTX has repurchased about 20% of the company’s shares for over $230 million while paying out nearly $30 million in dividends.  I believe that many of the clouds surrounding the company will dissipate over the next few months and people will realize that the company is easily worth about $42 per share (15x my FY09 earnings estimate of $2.80), or 40-50% upside from here. 

 

Jackson Hewitt operates a straightforward, primarily franchised business model.  The company is the second largest paid tax preparer in the U.S. with over 6,500 office locations and roughly 4% market share.  JTX generates revenue from fees for tax preparation and facilitation of financial products, mainly refund anticipation loans (RALs).  For the most part, these financial products are short-term advances on tax refunds.  Since JTX serves a generally lower income customer group, this refund is often their biggest financial transaction of the year; hence the desire for immediate access to these funds.  In providing these products, JTX acts as a gatekeeper: the company has two bank partners (Santa Barbara Bank & Trust and HSBC) who actually provide the loans and bear the credit risk of doing so.  These banks pay JTX a fixed fee for access to its customer base and a variable component based on volumes.

 

While I’m reluctant to dismiss casually the bear argument on JTX, I believe it’s important to assess the issues the company is facing realistically, starting with the government lawsuit and IRS investigation.  Apparently “tipped off” by a disgruntled employee, the Justice Department launched a very high profile case against one of the company’s franchisees, targeting 125 of his 200 locations (~2% of total offices).  The accusations include all manner of egregious forms of fraud that frankly sound like they were designed for the press rather than the courtroom.  In any event, it’s clear this franchisee is being made into an example.  What’s less clear is the substance behind the case and whether or not it directly impacts JTX and to what degree.  Our checks indicate that JTX’s franchisees are disgusted with the government and that corporate has told franchisees that improper returns will not be tolerated.  To this end, the company recently hired Fred Goldberg, a former commissioner of the IRS, to lead an internal review.  Some franchisees leapt to the defense of the targeted franchisee, claiming that he wasn’t fully involved with the business day-to-day and that the notion of him orchestrating a 125-location fraud is absurd.  Apparently the IRS is earning a reputation in the industry for bringing up “flaky” cases against tax preparers.  My hunch is that this will be an example of a splashy headline followed by little substance (ESI anyone?) or a small settlement a year from now.  Either way the government’s objective of tightening up tax preparation standards is accomplished.  So how does this impact JTX?  Our checks suggest that the “vultures are circling” on the 200 locations owned by the targeted franchisee.  It appears that they will either be seized by the company or sold to another franchisee – in either case they are highly likely to be open for tax season 2008.  Separately, we have learned that IRS has already completed its review of some of JTX’s other franchisees, and has given the all clear.

 

Another big concern involves the discontinuation of the “pay-stub” loan product and the risk that one of JTX’s bank partners (namely HSBC) pulls back from providing financial products entirely.  First, a little background: the bulk of JTX’s financial products are RALs.  These are essentially secured loans.  Credit quality is high because the bank has access to a completed tax return and the IRS, which quantifies the refund and pays the bank directly.  Banks like this product because the fees are high relative to the duration of the loan (usually a few weeks or months) and the low underlying credit risk.  Consumer advocates hate it because they prefer to annualize the fee and call it interest, which naturally has a very high imputed rate.  That debate aside, banks still like this product.  “Pay-stub” loans are another matter.  They are basically RALs taken to the next level: a loan based on your tax refund not when you file your return in, say, February, but based on a W-2, from, say, November.  JTX (along with everyone else) used this product as a marketing and retention tool.  The problem is that it’s apparently quite easy to defraud the banks using fake W-2s and other means.  Poor credit performance, which the banks obviously disliked, prompted them to discontinue the product.  As a result, JTX, H&R Block and Liberty Tax all publicly renounced the product for next tax season.  So what does this mean for HSBC?  I believe that HSBC is unlikely to cancel its contract with JTX.  It’s already out of a product it dislikes, and its remaining product is very profitable and growing as JTX expands.  Moreover, I would point out that HSBC as recently as last year completely renegotiated its contract with JTX so that it could gain access to the company’s customers on terms that were very favorable to JTX.  In other words, pulling the plug would mean a complete reversal, which strikes me as unlikely.  So is the world over if HSBC does terminate its contract?  I doubt it.  SBB&T specializes in this product and would likely be happy to pick up the business it recently lost to HSBC, to say nothing of another bank getting into the business.

 

Given these storm clouds, what signals are coming from people in the know at the company?  Bullish ones, it would appear.  In the month of May, management repurchased 1.0 million shares (~3% of shares outstanding).  We’ve also heard that franchisees have been buying stock personally.  In addition, we learned that there has been no slowdown in interest in franchise sales.  One explanation for all this activity is that everyone associated with the company, from management on down, is recklessly cavalier.  Another explanation, one that I think is far more probable, is that they realize this is quite a good business that is exceptionally cheap for a variety of unusual, and likely temporary, reasons.

 

In FY07, JTX filed slightly fewer tax returns than in the previous year.  For a company that’s growing its office base and has maturing locations, this result stunk.  So what happened?  Management was surprised by the weakness of the early season (its red zone) as more filers shifted to later in the season (an industry-wide phenomenon), H&R Block and Liberty Tax were a bit more on top of things competitively and the lawsuit filed in April created plenty of negative press.  Offsetting this volume weakness was pricing growth of nearly 8%, which allowed for overall revenue growth of 6.5%.  FY08 should be considerably better.  Pricing growth will be +5-7% (in-line with historical levels), but volumes should expand in the low-to-mid single digits driven by store maturation, new territory sales and, frankly, easy comps.  Management estimates that they still only address 40% of the market, implying that there are many more franchises to sell.  Meanwhile, office density remains low at 2.0 offices per territory vs. a target of 3.0.  To improve execution, which was previously lacking, the company recently installed a new COO and his team from Western Union.  The franchisees with whom we spoke were quite positive on the addition, indicating that he’s already demonstrated a much more hands-on style.  In addition, management is quite focused on expanding its late season presence so that the company is more balanced in FY08 than in FY07.  The reality is that the bar is set fairly low for the upcoming tax season with respect to revenue growth, and I expect the company to surprise on the upside.

 

The tax preparation business is undeniably attractive.  The business generates recurring revenues, high margins and impressive returns on capital.  In volume terms, the industry is a modest secular grower as paid preparation gradually takes share from do-it-yourself, while in the paid preparation segment, the branded providers (i.e. JTX, H&R Block and Liberty Tax) are gaining share from mom and pops.  Pricing, meanwhile, is opaque and demand inelastic (for both tax preparation fees and financial products).  Industry pricing is especially compelling because from a customer’s perspective, you don’t know what you’re paying until the whole process is over – and after that painful process, you’re certainly not going to go shop around.  Moreover, H&R Block, which has a more mature business and therefore greater reliance upon price increases to drive revenue growth, is the industry’s price leader.  The government also helps out by continuing to deepen the tax code’s complexity.  This has the dual benefit of scaring consumers into using paid preparation rather than doing it themselves and requiring additional forms to be completed, which boosts prices even more.  With the prospect of the Democrats, who favor tax laws that tend to increase tax code complexity, gaining control of both the White House and Congress in 2008, it seems likely that complexity will worsen further, much to JTX’s advantage.

 

Jackson Hewitt’s business model requires next to nothing in terms of capital investment.  There are also not a lot of M&A targets or logical business line expansions.  So what is a management team to do?  At JTX, management buys back stock aggressively and pays a reasonable dividend.  As mentioned above, management has repurchased about 20% of the company since the IPO three years ago.  Approximately $100 million remains on the current buyback authorization (representing about 11% of the current market cap), which I expect to be fully used within the next 12-18 months.  Balance sheet leverage is modest at roughly 1.2x estimated FY08 EBITDA, giving the company added flexibility.

 

Can any long thesis be complete without an LBO section these days?  In the case of JTX, I believe it’s actually an intriguing possibility that the current valuation certainly enables.  With the stock now trading at a about 7.5x my estimate of FY08 EBITDA, I believe a deal could easily be done at $40, which would imply a multiple of about 9.6x FY08 EBITDA, which would be at the low end of deals being done today (involving companies with greater capital intensity and less predictable free cash flow I might add).  Assuming the same exit multiple in around four years’ time, one could earn an IRR in the 30% range.  While a buyout certainly isn’t integral to my thesis, it does help to demonstrate how inexpensive the stock currently is.

 

(amounts in millions, except per share data)

 

Price / Share          29.89

Shares                    30.1

Market Cap           898

Net Debt                171         

Enterprise Value   1,070

 

FYE: April                              2006A     2007A     2008E      2009E

 

Tax Returns Filed                       3.7           3.6           3.8           4.0          

Average Fee / Return                 178          192          203          213

 

Revenue                                     275          293          321          347

EBITDA                                    123          135          148          159

EPS                                           1.66         1.98         2.35         2.80

FCF                                           101           67            86            96

 

EV/EBITDA                                                               7.5x         6.9x

P/E                                                                            12.7x       10.7x

FCF Yield                                                                   10%        11%

 

(1)     My numbers exclude any one-time charges or other costs relating to the lawsuits.

(2)     EBITDA is shown before stock-based compensation expense.

 

1.   I could be too optimistic about one or more of the storm clouds over the company.  The Justice Department could get increasingly aggressive and target additional franchisees or the company itself.  Given the one-off nature of the current lawsuit, this scenario seems less likely by the day.  I could also be wrong about HSBC, which could decide that after the sub-prime mess, it no longer wants to play in this business.  Again, I think this is unlikely, mainly because there’s not a great economic argument that justifies exiting the RAL business and HSBC has consistently shown interest in serving lower income (i.e. more profitable) consumers.  A renegotiation of the contract with less favorable terms to JTX is, of course, a possibility.

 

2.   Consumer advocates might decide that eliminating RALs (or gutting pricing) is their new #1 priority.  Every few months there is a negative headline about a consumer advocate or congressman going after RALs.  I doubt this will change.  My suspicion, however, is that most groups are currently mobilizing for the sub-prime mortgage mess, which involves millions of people and billions of dollars.  As a result, I think that RALs will not get much interest for the next 18-24 months.

 

3.   Plenty of competition remains.  H&R Block and Liberty tax are not going away and I expect competition for customers to remain quite keen.  It’s worth highlighting, however, that all the players understand this is a business with good pricing power and that isn’t likely to change.  Consider it a relatively comfortable oligopoly.  H&R Block has to raise prices to grow, which enables everyone else to follow.  Liberty Tax, which has the least mature business of the three major players, is effectively raising prices at an even faster pace as it allows its deeply discounted prices at newer locations to roll off.  Even in the financial product space, where H&R Block claims to be cutting prices, the truth is quite a bit murkier.  While technically the company is reducing headline RAL pricing, in order to receive this discount, a customer must open an H&R Block bank account, hold their money in the account for a certain period of time and expose themselves to a variety of other even less transparent fees.  In fact, an official at the company assured me that it will continue to receive the same level of economics under this new RAL pricing scheme.

 

4.   JTX has a small window in which to get it right.  The tax season is a compressed period of time in which to execute.  This past season, JTX stumbled a bit, much like H&R Block did the year before.  While this timeline obviously isn’t going to change, I believe that the company is taking the right steps operationally to improve execution in FY08.