|Shares Out. (in M):||14||P/E||0||0|
|Market Cap (in $M):||171||P/FCF||0||0|
|Net Debt (in $M):||12||EBIT||0||0|
We had originally planned to post (or reverse course on) our thesis on TAXA after their shareholder meeting next month and after tying down some other in-process research tracks, but the strategic review announced last night has brought forward the timeline. So, while we haven’t yet tied a bow around our work, we believe there is sufficient reason to recommend TAXA now rather than later. Below are our (hastily) summarized notes on the situation, plus a healthy heaping of reasoned conjecture. We have skipped the tables and formatting in the interest of time (also because of how infuriating and time consuming that is on VIC), but everything should be easy enough to track via public filings.
For additional background, please refer to Kruger’s excellent write-up.
Liberty Tax (OTC: TAXA) is the 3rd largest tax preparation firm in the country, behind H&R Block (shorthanded HRB hereafter) and Jackson Hewitt (shorthanded JH hereafter).
Earlier this year, Vintage Capital (15% owner), Cannell Capital (13% owner, top 5 position if this were reported in 13F) and B Riley (22% owner) took over control of the firm from the scandal-ridden CEO and founder, John Hewitt. John Hewitt no longer has any role at the firm and sold all of his shares to Vintage. Vintage and B Riley together hold a plurality of board seats.
At approximately the same time, TAXA fell off the exchange because they were delinquent on their SEC filings. Importantly, KPMG had resigned not due to an accounting disagreement, but because they objected to how the CEO ran the company. The firm subsequently hired Cherry Bekaert and managed to file its FY2018 10-K (ending in April), but is not current on other filings yet.
Last night, TAXA PR’d that they had initiated a strategic review soliciting buyers, due to an inbound offer at $13 from a PE shop this is not affiliated with Vintage.
In light of the receipt of the unsolicited proposal, the Board of Directors of Liberty Tax has determined to commence a review of strategic alternatives and solicit other potentially interested parties regarding an acquisition of the Company. “We remain confident in Liberty Tax’s strategic plan and the significant growth opportunities available to us. At the same time, we are open-minded and willing to consider any transaction that maximizes value for our stockholders,” said Chief Executive Officer, Nicole Ossenfort.
Scummy, But Decent, Business with Room to Improve
TAXA covers approx. 3,600 tax preparation stores in the US and Canada, primarily built on a franchise model. Reading their historical financials and that of HRB and JH reveals that the industry just about breaks even on the tax preparation itself, and make most of their profit on add-on services, such as the Refund Anticipation Check, interest-free advances, warranty-like products and other services. (Note that we’re talking about store-level financials here, which speak to the viability of the industry. The corporate entity can still make money from franchise royalties even if the stores are doing poorly, but of course, if the stores don’t make money, then the game ends at some point.)
JH is a useful, though imperfect, analogue to TAXA. After encountering financial distress in 2010 due to Refund Anticipation Loans being effectively banned, they went through a pre-pack and were owned for many years by HIG Bayside. They were sold to Corsair Capital, another PE shop, earlier this year. Despite not being a public reporting entity, their financials can be tracked via their annual franchise disclosure documents.
It is notable that JH was able to improve profitability while shrinking their store base over this time. Recently, they grew from $32 mm EBITDA and 6,252 stores in April 2015 to $43 mm EBITDA and 5,746 stores in April 2018. (During that same time period, TAXA did exactly squat while also shrinking their store base.) There is massive dispersion in JH's unit profitability, which explains how churning off poorly forming units may not hurt the corporate numbers. Cash flow was likewise very impressive after digesting the initial regulatory change. While HIG is unwilling to reveal their exit multiple to us, it is likely they did very well with their investment.
JH’s latest FDD is at the below link. TAXA’s FDD can be found in the same place.
We believe there is substantial opportunity to improve TAXA’s business. If you walk into a TAXA franchise and then drop in on a neighboring H&R Block, you’ll immediately notice a world of difference in ambiance, marketing support, professionalism and automation. This comes from our limited field research in NYC, which is ongoing, and during the off season, so it may not be representative if anyone cares to drop in on their local store.
There are major differences in the unit model between each of the 3 companies, resulting in vastly different return processing volume metrics and unit-level economics, so it would be disingenuous to simply say for example that processing volumes at TAXA offices can simply catch up to HRB (HRB processes 4x the returns per store that TAXA does). Another example: JH’s stores average >$100k in unit revenue vs. TAXA’s store average $76k. (Note there are some differences in presentation of numbers, so economic comparisons are not clear cut, and TAXA stopped providing sampled unit financials in 2016.)
A few franchisees we spoke to were discontent with how corporate was running things, though did acknowledge the marketing and systems benefits that led them to franchise instead of being independent. One franchisee said the district manager was very excited by new regime, although was not clear on the specifics of why. Hopefully, more color to come on these points shortly.
Despite how sad the TAXA stores look and several bouts of catastrophically bad strategic decision-making, TAXA has been a cash flow machine. They also have a motivated franchise base (motivated by money and tied in by their franchise agreement). For either Vintage or for another PE shop, there should be a cornucopia of low hanging fruit here to improve both the top and bottom line, given how terribly the company has been run previously.
We believe there will be substantial mid-market PE interest in TAXA, but that there is only a 60/40 chance that the process results in a sale.
- Blue pill: The owners receive strong interest, decide a hefty IRR from their approx. $9 entry point is good enough, and opt to move on. Many of the hard restructuring changes are probably better accomplished outside of earnings scrutiny. Just spitballing here, but there may also be some reluctance if Vintage is expected to do the heavy lifting, while not able to capture the lion’s share of the economics given the other large holders' positions . While we can only guess at the board's motivations, we would expect any acceptable offer to be somewhere above $13. We haven't thought too hard yet about strategic buyers, but a few may show up. Aside from horizontal mergers where market definition lawyering would have to be the antidoe to antitrust issues, there is some interesting potential for retail cross-sell business models.
- Red pill: The company goes it alone. We believe the public market valuation of this fixer-upper to be significantly above current levels today and likely much higher as it gets polished up with time. This stock was trading in the high teens earlier this year and in the 20's not too long prior. If offers arising from the strategic review do not meet the board’s expectations, Vintage’s PE team should have the capabilities to drive the bus themselves, probably with some management fees and other concessions though.
As an aside, we would be extremely uncomfortable owning TAXA under a 100% Vintage regime due to risk of PE shenanigans. However, with the checks-and-balances that public equity investors like Cannell and B Riley provide, we believe minority shareholders will be treated fairly. While not having had the chance to observe board dynamics, we would not be surprised if there wasn't quite a bit of tension between the board members and their divergent interests.
Re: valuation, we have their 4/30/2018 balance sheet as a starting point. While it shows net debt of around zero, we know they’ve spent a fair deal on some crony-tastic severance payments and professional services since then. We don’t know what the right number is, but impute $12 mm net debt for this exercise. The company only generates FCF in its Q4 (following the April tax season), so we're talking about seasonally adjusted EV rather than whatever the BS might look like during the off season.
Using that starting point, let’s take some very rough cuts at valuation. We're using the low end of their recent financials for conservatism. Small changes in assumptions can create massive changes in the output, hopefully to the upside.
A.) Assuming a steady state vanilla FCF of $20 mm and HRB’s levered FCF yield of 8-10%, you’d get $13 to $17 in per share value.
B.) Assuming a steady state vanilla EBITDA of $40 mm and HRB’s LTM EV/EBITDA multiple of 6x-8x, you’d get $16 to $22 per share.
C.) We haven’t dug our LBO model out of the closet, but it would presumably yield a pretty good result if the leveraged loan markets stay open. JH was carrying more than 4x Debt/EBITDA after their last levered recap.
D-1.) Assuming TAXA can get to a margin profile in more line w/ peers, there is much more upside.
HRB operates at ~30% EBITDA margins, primarily with well run corporate stores with some franchise mixed in.
JH provides much better franchise vs. corporate disclosure than HRB, so if we napkin math convert their corporate offices into franchise offices to see the resulting operating margin, we can back into what looks like ~40% EBITDA margins on a pure franchise basis.
With TAXA somewhere in the mid-20%ish EBITDA margin range, it is not hard to envision a path for TAXA to achieve some ludicrous sounding improvement in profitability. Franchise models, after all, should have much higher margins.
This is highly, highly inexact work, but if anywhere near correct, the possible operating leverage at TAXA is massive:
- Assuming cost controls (or revenue enhancement) can improve margins by 3%, you’d be improving valuation by $2-$3.
- If we dare to dream, 10% margin enhancement may sound crazy, but, if possible, we’re in valuation ranges of $22 to $32, assuming no growth. Maybe consider this a 2021-type proposition.
- This thought exercise is flawed in many respects, not only due to input assumptions, but due to real world considerations. For example, both HRB and JH have focused on corporate store growth at the expense of franchise growth. There may be quality control and compliance reasons to focus there, pointing to deficiencies in the franchise model. Also, JH improved margins not by cutting SG&A, but by spending to improve its capture of add-on products. A more nuanced view of TAXA’s opportunity set would involve not only removing dead wood, but also prioritizing better support to franchisees in pursuit of higher unit economics - but we're just hedge fund hacks, so simple is probably better.
Given the information vacuum and poor history, it does take some faith to invest in TAXA. However, just as there is a place for Wendy’s to thrive in the cut-throat fast food business, we believe there is room for TAXA to do well in the commoditized tax preparation business. An investment here would be predicated on these pillars:
a.) There are clear reasons why the stock is likely to be mispriced today
b.) Governance is now fixed and all of the key actors are now aligned
c.) While the range of numerical outcomes is wide, the opportunity set is intuitively huge for both PE and public investors
d.) Win-win outcomes in either the blue pill or red pill scenarios, should one be willing to stomach low liquidity and price choppiness for a while
Due to its OTC status, acquiring a significant shareholding in TAXA may be difficult, though we would expect periodic news flow to create various windows of opportunity. This is a good sized position for us, but we have been using today's liquidity to accumulate more shares, despite the jump. Shares are likely to drift after the initial bout of announcement related trading, so we would expect more opportunities for patient investors to graze into a position.
- If they take the red pill, TAXA goes back into OTC purgatory for a while and your mark-to-market may get dinged, not to mention having no liquidity. However, relisting is probably 3-6 months away, given financials should be current very soon. It may then take a clean tax prep season after things have been fixed (ie. April 2020) for the company to trade to its proper value. Accounting problems could still arise, but it is not clear the risk here would be worse than any other public company. Also, for now, it does not look like TAXA intends to pay out the juicy dividends it did before it was delisted.
- The 2018 tax year will be the first under Trump’s new tax program. Should overwitholding be far lower than in prior years (ie. refunds are small because of W4 peculiarities), the golden goose that is the refund add-on products would likely be unattractive to clients, crushing profitability. GAO work and Wall Street analyst estimates give us some comfort that things will not have changed for the worse next year. Similarly, we are comfortable with the risk of disintermediation due to online self-preparation, free e-file, etc.
- Various federal and state regulatory agencies squint hard and shake their fists at the add-on products. Should they decide to change the rules, as they have in the past, it could devastate margins. In 2016, a swath of TAXA franchisees were shut down for filing fraudulent tax forms. This is not a business run by boy scouts, and headline problems or criminal/civil liabilities could arise.
- CEO and CFO are legacy Liberty Tax executives picked by the now exiled founder. Not clear at all how capable they are, though the CEO runs her own (we assume) highly successful TAXA franchise. We would assume the new owners would throw them out if they do a bad job, but this would slow any value realization in the shares.