|Shares Out. (in M):||14||P/E||11.48||0|
|Market Cap (in $M):||182||P/FCF||8.47||0|
|Net Debt (in $M):||6||EBIT||0||0|
Liberty Tax is an operator and franchisor of neighborhood tax stores which provide tax return preparation services for mid to low-income individuals, generally with less than $50,000 in annual income. Dressed in green Statue of Liberty costumes while flagging down customers off the streets, one might think this is a silly business, yet they are among the three largest tax preparation firms in existence, the others being the behemoth, H&R Block, and Jackson Hewitt, which itself was started by John Hewitt, the same entrepreneur who started Liberty Tax twenty years ago, and who is now its current CEO. From 2010 to late 2014, Liberty Tax was a growth story. Revenues increased from $101 million to $160 million over five years, while total offices expanded from 3531 to 4438. By the fall of 2014 the stock had reached a high of nearly $40 per share. Yet after all these years of impressive growth, the company suffered three consecutive years of disappointing performance, due in part to management missteps, failed gambits, regulatory compliance problems and a bit of bad luck, all detailed below. By the end of fiscal 2017, revenues had leveled off, total offices had fallen to 4077, and the stock had traded to a low of $10. Nevertheless, despite the recent setbacks, most of which appear to be transitory, Liberty Tax has a long history of uninterrupted profitability, and even this year, one of its most disappointing, the company generated more than $27 million in free cash flow. With only 4,000 stores compared to HR Block’s 10,000 stores, there is a case to be made that Liberty will once again become a growth story. And even if this never occurs, the stock seems cheap for a stable business which should, at least, be able to expand gradually. Using the last three to seven years of historical free cash flow, which encompasses both periods of growth and contraction, the company is now trading at an EV to FCF multiple of between 8.5 and 9.2x, and also pays a dividend of 0.64 per year for a yield of 4.9% (ex-dividend this Wednesday).
Three years of disappointment
Investors were excited about the tax industry in 2013 and 2014 partly because of two external catalysts: the implementation of the Affordable Care Act and the Obama administration’s immigration reform proposal. The belief was that the increased complexity of administering the ACA through the federal tax system would make filing returns prohibitively complicated for individual filers and would drive them to paid preparers. Similarly, it was believed that President Obama’s immigration proposal would lead to millions of first-time tax returns being filed by formerly-illegal immigrants as well as the possibility that millions more would be filed by these same immigrants in order to take advantage of the Earned Income Tax Credit, which they were entitled to receive under the Obama plan for up to three previous years. Since formerly-illegal immigrants were unlikely to file their own tax returns online, the lion’s share of this new business would go to the big three tax preparation companies, particularly Liberty Tax, which launched their Siempre Tax store concept in part to take advantage of this new demographic.
By 2015 however, it became clear that neither of these catalysts would materialize as expected. In addition to having dedicated a significant amount of resources and time to launching their Siempre Tax concept to attract Latino filers, particularly illegal immigrants for an amnesty program that would never materialize, the company had also spent the better part of fiscal 2015 instructing their franchisees to become certified insurance agents so that they could offer medical insurance products alongside their tax preparation services. Instead of working with their franchisees to add more offices and to prepare for the upcoming tax filing season, they focused their franchisees' efforts during fiscal 2015 on the ACA, which they thought would yield a deluge of new filers and new product revenue. The original idea was actually a good one: as part of their service to customers, Liberty Tax would figure out how much of a premium tax credit their customer would qualify for, or conversely how much of a penalty they would pay, and then offer a particular health insurance solution tailored to maximize their refund. The company also felt it would be natural for these customers to return to Liberty offices the following year to be sure that they received the promised tax credit. Unfortunately, for a variety of reasons, including the fact that the ACA penalties were never enforced and the promised number of newly-insured people never materialized, this gambit never worked as planned and Liberty ended up eliminating the health insurance offering completely. The net result was that Liberty lost an entire year of expansion due to a misplaced gamble on the ACA.
In fiscal 2016 the company committed another strategic blunder by launching what management refers to as the “company store cluster program”. At the time this idea was conceived it was far easier to sell existing territories than brand new territories. Franchisees who wanted to exit the system were finding it very easy to find a buyer for their business while the company’s sales of new territories were slowing down. In response, management decided to launch 80 new company-owned stores in clusters: 8 in one city; 10 in another; 6 in another; the idea being that clusters would require only one manager for all the stores and that once these stores had shown one or two seasons of success, the cluster would attract a large, financially secure buyer. Unfortunately, the stores didn’t perform well under company management and the investment was a flop. Only a few of the clusters were ever sold to buyers, while most of the stores continued to be operated by the company or performed so badly that they have been shut down completely. The poor outcome of this experiment affected financial results in fiscal 2016, and because of the increase in poorly performing company-owned stores, still remains a problem today.
However, the most serious problem to confront the company also occurred in fiscal 2016, one which caused lasting damage to its reputation and resulted in a significant drop in total franchisees and franchised offices. Throughout the year, franchisees in the states of Michigan, Maryland, California, New York, South Carolina and Illinois were accused by regulators of deliberately falsifying information on tax returns in order to receive inflated tax refunds for their clients. Some of these franchisees were shut down completely, others were barred from preparing state returns, while others lost their eFile privileges. See links below for a sample of the press coverage and Justice Department complaints:
The end result was that over 100 offices were eventually ensnared in a compliance dragnet and were shut down for much of the 2016 fiscal year. Fallout from the fiasco continued well into fiscal 2017 due to negative press coverage, resulting in few of the company’s existing franchisees being willing to add new stores and prospective franchisees being dissuaded from purchasing new franchises. The company reported a drop in franchised locations of 462 offices in fiscal 2017, from 4177 to 3715 offices. Some of these franchise offices were absorbed by Liberty and operated as company-owned stores, which is why, during fiscal 2016 and 2017, in combination with those stores absorbed due to the failure of the cluster store program, there was a significant jump in company-owned locations.
Compounding these problems, the company admitted on their latest conference call that they had done a poor job of managing their company-owned stores in the 2017 fiscal year, which had ballooned from a low of 182 stores in fiscal 2015 to 362 stores in fiscal 2017. The company was ill-prepared to manage the large number of absorbed franchise locations and, with much fanfare, has recently hired a new COO to orchestrate a turnaround.
In response to the problems with tax fraud among their franchisees the company recently had the following to say:
"Since that time we have beefed up our own internal compliance group, looking for filing patterns. We also have a secret shopper program. We doubled or tripled the number of secret shoppers this year. We did a really good job jumping on it, cleaning it up, and improving relations with all the regulators. There was no repeat of the compliance issues in the year that just ended [fiscal 2017]. So we should be in a much better position going into this year [fiscal 2018]."
The purpose of going into all the above detail regarding the problems that have recently afflicted the company, and which ultimately caused Liberty stock to fall by 75% to a low of $10, is to show that none of these events, not the crushed expectations for immigration reform or the ACA, not the failure of the company’s cluster program, nor the fraud among franchisees or the resulting bad press, nor even their seeming inability to manage company-owned stores, is a serious enough problem to dramatically alter the long term prospects for the company. In fact, all these set-backs are short term in nature and will be resolved or forgotten over time. Meanwhile the company's core business remains intact. There is one threat to the company however that deserves special treatment: the rise of Intuit and the online Do-it-Yourself market.
The Do-It-Yourself Market (DIY)
A significant, and possibly existential threat to Liberty tax is the continued impact of Do-It-Yourself online software on brick and mortar tax stores. Intuit, the leader in online tax software with 65% market share, in their presentation dated March 7, 2017, on p.21, states that the online DIY market has grown from 27% market share of all returns filed in 2007 to 40% market share today and continues to take approximately 1% of market share per year. Intuit also noted in their Q4 conference call however, that the shift from assisted tax returns to DIY had slowed significantly this year compared to the last several years. There are arguments on both sides as to whether the DIY market will continue to overtake the assisted tax return market and whether or not it will eventually replace tax stores completely. Supporters of Intuit will argue that coming advances in artificial intelligence and the continual improvement in the ease-of-use and accuracy of their software will eventually make tax stores obsolete. Indeed, there is a strong incentive now for people to switch to online software since the two major competitors in the industry, Intuit and HR Block, are locked in a brutal price war with both companies now offering some portion of their online software packages for free – Intuit with their Absolute Zero promotion and HR Block with their More Zero promotion. Liberty Tax by contrast, although they have an online offering, made the strategic decision to abandon the online market in favor of brick and mortar tax stores, making the company a pure play on the continued viability of these stores in the future and necessitating that any investor in Liberty Tax have an opinion on the near-term and long-term direction of the DIY market. Management at Liberty Tax recently commented:
"To make software as easy and useful for the customer as Intuit’s software would require a major capital investment on our part. And we’re not going to do that. So we have an online offering. We don’t spend much time advertising it at all. It’s slightly positive to our bottom line – under $1 million. It’s just there but it’s not a growth engine at the moment. Intuit’s software is pretty great. They add a lot of features and functionality every off-season and they’re doing it for free too now. And the advertising is expensive. Intuit spends over $100 million per year in advertising. So does Block. You just can’t compete."
Certainly demographics are moving in the right direction for Intuit and in the wrong direction for Liberty. We now have a generation of adults and young adults who have become accustomed to doing everything online and it is difficult to believe that they will toss aside this propensity when filing their tax returns and somehow end up at a Liberty or HR Block tax office. Nevertheless, much of Liberty’s clientele is a lesser-educated, poorer group of citizens, who in some respects are the same clientele that frequents pay-day loan stores. Average incomes for their clients are significantly below $50,000 and a large number of them are lured into Liberty Tax stores with the promise of advance refunds, which are essentially interest-free loans made by Liberty Tax to their clients who desperately need the money now and cannot wait two months to receive a refund from the government. Liberty also offers an immensely profitable Refund Transfer product, essentially a high interest rate loan, which allows their clients to defer payment of their tax preparation fee until their refund is received, for a one-time fee of $49.95. At last count, nearly 50% of their customers took advantage of this offering in the latest tax season, a total of 800,000 clients, amounting to roughly $40 million in high-margin financial product revenue. As long as there are people who are desperate to receive their refunds early and who are willing to pay high interest rates for the privilege of deferring their tax preparation fees, and provided there is not a regulatory crackdown on such practices (see risks section of 10-K), Liberty is likely to hold onto this segment of the tax preparation market for the foreseeable future. Their clients, not being inclined to attempt online DIY preparation, and desperate for a quick advance on their refund to pay the rent, may continue to frequent tax stores for the same reasons that pawn shops, rent-to-own stores, and pay-day loan stores exist today. Additionally, much of Liberty’s clientele does not have access to traditional banks for the deposit of IRS checks or do not speak the language well enough to be certain of filing their returns correctly and depend on tax store assistance to ensure they do it correctly. In particular, workers of Hispanic descent who, according to the company, are “afraid of the IRS and do not want to take the chance of filing inaccurate returns no matter how simple”, have been very loyal customers. Partly for this reason, and partly to take advantage of immigration reform as previously mentioned, Liberty Tax launched the new franchise concept called “Siempre Tax” to target these customers, which has grown to 159 locations over the last few years.
For more on the controversial side of the tax preparation business see the article below:
Setting aside these poorer filers for the moment, it is probably still the case that a large portion of the tax preparation market will steadfastly refuse to do online returns and will continue to frequent the tax stores. Intuit’s own CEO, the leading provider of both online and offline tax software, made a good point recently in a room full of investors when he compared doing taxes to mowing the lawn. “Lots of people own a lawnmower and yet almost nobody mows their own lawn. It’s the same way people feel about their taxes”, he says. “They know they can do it, but they just don’t want to.”
Despite its recent problems, and the sometimes controversial nature of its business, Liberty could once again become a growth story. The overall tax preparation market is a growing industry and the number of returns filed has been growing at about 1% per year since 2001. As can be seen from the two IRS publications linked below, growth in the number of individual tax returns filed each year has increased steadily from 130.3 million in 2001 to 150.7 million in 2016, so this rising tide works in Liberty’s favor.
Liberty will also point out that theirs is the only national brand with prime territories still available and that their largest competitor, H&R Block, processes three times as many tax returns per store and has five times as many locations, indicating, they say, that they can still capture substantial market share. They also point to the slowdown in the speed at which DIY software is taking market share as a sign that the movement to online tax preparation is nearing a zenith.
It is also the case that current proposals in Congress to require all tax preparers to become certified would cause a reduction in the number of competing single-store tax preparers who currently represent about 65% of the tax preparation market and are presently required to have nothing more than a Preparers Tax ID Number (PTIN) in order to prepare returns. Requiring these individual tax preparers to become certified would thin the competition and would result in an increased number of customers visiting the large tax preparation firms.
Debt, EV and Valuation
Liberty Tax shows significant revolver debt on their balance sheet in three out of four quarters of every fiscal year, particularly in Q3 when revolver debt can reach $150 million, yet the company is required to pay off this debt and maintain a zero balance for 45 consecutive days each fiscal year as a condition of their credit agreement. During fiscal 2017 this requirement was met from May 1st to June 15th. Furthermore, looking at their quarterly financial statements one sees that current assets plus notes receivable exceed total liabilities in every quarter by between $18 and $45 million, which is more than enough to pay off all revolver debt as these receivables are paid down by their franchisees. This happens every year around tax time as they begin to receive tax preparation fees from customers. During the off-season, franchisees receive loans from the parent company for working capital, payroll and other expenses, which is why the revolver reaches a maximum by the end of the third quarter, January 31st. Balances on the revolver therefore, should not be counted as debt when calculating enterprise value. The company does have approximately $18.4 million in long-term obligations which includes mortgage debt as well as the term portion of their credit facility and these balances should be included. Also, in fiscal 2017, cash and cash equivalents were never lower than $3.5 million during the entire fiscal year, even after the distribution of $8.9 million in dividends to shareholders. So, of the $16.4 million in cash and cash equivalents on the balance sheet at the end of Q4, it’s safe to say that at least $12.4 million is not needed for working capital. Therefore, I calculate the enterprise value as follows:
14 million shares * $13 per share = $182 million Market Cap
Add: $18.4 million in long term obligations
Subtract: $12.4 million in cash and equivalents
Enterprise Value: $182 + $18.4 – $12.4 = $188 million
On the cash flow side, the company has averaged approximately $20-23 million in FCF per year for the last several years, depending over which set of years you choose to average (see Table below). And since these years represent periods of both growth and contraction, it’s fair to say that Liberty is trading at an EV to average FCF multiple of between 8.2 and 9.4. EBITDA is not the best measure for this company, partly because interest expense is really a marketing expense and should not be added back, however it's worth pointing out that the company has generated adjusted EBIDTA of about $42.5 million per year consistently for the last few years and is now trading at an EV to EBITDA multiple of approximately 4.4, whereas its largest competitor, HR Block, which reported fiscal 2017 EBITDA from continuing operations of $905 million, and has $1.2 billion in non-seasonal long term debt and 210 million shares outstanding, trades at an EV to EBITDA multiple of about 8.6.
|Total returns USA and Canada (millions)||1.946||2.075||2.116||2.201||2.247||2.162||2.016|
|Adjusted EBITDA (millions)||32.205||35.331||40.424||44.734||42.787||43.208||42.404|
Should the company be able to return to growth in the number of franchisees and the number of tax returns filed per office perhaps they could garner an EBITDA multiple closer to that of HR Block. For example, if all they do is achieve their prior year consensus revenue estimate of $187 million combined with an average historical EBITDA margin of 26%, this would yield EBITDA of $48.7 million and would probably result in a stock value for Liberty of between $15 and $29 per share, making the reasonable assumption that the future EBITDA multiplier stays somewhere between the current Liberty Tax multiple of 4.4x and the current H&R Block multiple of 8.6x (see table below). This would be an appreciation of between 15% and 125% over current levels.
|Implied EV (mil)||219.15||243.50||267.85||292.20||316.55||340.90||365.25||389.60||413.95|
|Implied Stock Price||15.26||17.00||18.74||20.48||22.22||23.96||25.70||27.44||29.18|
Even a stabilization of the business at $177 million in revenues, the lowest of the current consensus revenue estimates for fiscal 2018, combined with an EBITDA margin of 26% and an EBITDA multiple just one point higher at 5.5x would put the stock at $18. Not much needs to happen for investors at these levels to make money particularly as we are getting paid a nearly 5% dividend to wait.
A Final Comment
Liberty Tax is unique in the sense that nearly all the financial news of consequence comes within the three-month period from February to April so there may not be a pressing reason to rush out and buy the stock. There could be unexpected news in the off-season of course, and certainly at very low valuations it could bounce off the lows with no news at all. But I think it is probable the stock will trade in the range of $10 to $14 for some period of time. Perhaps in anticipation of the ex-dividend date arriving this Wednesday the stock has risen over the last few weeks. After this date, there could be renewed weakness and an opportunity to buy at a slightly cheaper price.
DIY online software gradually supplants tax offices
More revelations of fraud among franchisees
Company unable to profitably manage company-owned stores
Legislation passed in Congress which radically simplifies the tax code
Potential regulation of Liberty’s Revenue Transfer product or future litigation which may force the company to categorize this product as a loan to the customer and would therefore require standard loan disclosures
Improved performance in company-owned tax stores
A return to growth in the number of tax offices and returns filed
Passage of legislation requiring certification of tax preparers
Immigration reform incentivizing illegals to file tax returns