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Higher Returns for Our Top Personal Services Pick

We think there's a winner in the tax preparation industry.

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The personal services industry encompasses a wide array of businesses. Under this grouping we include firms that service consumers but don't seem to fit among the traditional consumer-related names. In this article we will focus on the tax preparation services industry. Over the last few years a seismic shift has occurred that has left the long-time dominant players within this industry scrambling to maintain their market-leading positions.

 H&R Block (HRB) and  Jackson Hewitt (JTX) have led the individual tax preparation industry for decades. However, the market share for both firms has taken a material hit in the last few years as increased competition from traditional and nontraditional rivals takes its toll. This increased competition has given tax preparation customers greater choices and lower prices and created a secular head wind for both H&R Block and Jackson Hewitt. The downturn in the employment market has also been taxing as lower wage earners, a significant portion of the customer base for both firms, have been disproportionately affected by the losses within the labor market. This dynamic has and will continue to mean a lower number of tax filings over the near term. Both H&R Block and Jackson Hewitt have struggled to cope with these significant obstacles, and the competitive dynamic will most likely continue to change over the next several years. However, the degree to which each firm is affected is dependent upon their competitive positions. Here we look at the major challenges both companies currently face and pick the firm we believe is best-positioned to overcome these challenges and reward investors.

The DIY Network
During the mid- to late 2000s software/online-based tax preparation services have surged, and leading the way has been software developer  Intuit (INTU). Intuit's TurboTax product has dominated the do-it-yourself market--approximately more than 3 times as many tax filings are done through TurboTax than through H&R Block's comparable TaxCut product. This is even more impressive as we currently see no serious challenger to Intuit. The second-largest tax preparation services player by market share, Jackson Hewitt, has yet to develop a do-it-yourself product, and as previously mentioned, market leader H&R Block owns only a miniscule share of the software/online submarket. Ceding the first-mover advantage to TurboTax has been costly to both major tax preparers, and we believe this trend will most likely continue.

Intuit has a major factor working in its favor--switching costs. Its product does cost slightly more than H&R Block's TaxCut product; however, TurboTax saves a customer's critical information each year, and all returning customers have to do is upload their new W-2 information. Customers moving to another software/online product would need to input their tax profiles all over again. This helps Intuit maintain a significant portion of its customer base on a year-to-year basis and maintain its large market share.

Over the longer term, the do-it-yourself option also raises concerns about pricing for the traditional players. Software/online tax preparation options are priced significantly less than brick-and-mortar branch services. As a greater portion of H&R Block's and Jackson Hewitt's customers migrate to do-it-yourself options, profitability may come under pressure. Software/online tax preparation services are cheaper to provide and highly scalable. However, both tax preparation market leaders are relatively new to this submarket, and the ability to build sufficient scale to offset the negative effect of the shift in product mix will be difficult in the near to medium term.

Familiar Faces at New Places
Given the problems the major tax preparation firms have endured over the last few tax seasons, both H&R Block and Jackson Hewitt have made drastic changes to their leadership structures. Hedge fund manager Richard Breeden became H&R Block's chairman in 2007, and he replaced Mark Ernst with Russ Smyth as CEO in 2008. In June 2009 Jackson Hewitt took a similar step, replacing former CEO Michael Yerington with Harry Buckley. Both Buckley and Smyth come to their respective positions with a great deal of experience running franchise-type operations. Buckley has had a long career in the tax preparation industry with both H&R Block and Jackson Hewitt. These recent actions show the concern with which both firms are viewing their current competitive positions. Not only is there a threat from the aforementioned product mix-shift dynamic, but new brick-and-mortar branch competitors have become more aggressive. Jackson Hewitt founder John Hewitt founded Liberty Tax, which has steadily grown and garnered a material portion of market share over the last several tax seasons. New competition has also sprung up from check cashing, payday lender, and smaller tax preparation operations. These fairly new competitors have also taken a significant amount of market share and have pressured pricing throughout the industry. Competition from accounting and law services firms has also played an antagonistic role.

This increased competition has led to major struggles throughout the branch networks of both major tax preparation players. Lower revenue and profitability per branch has been a constant theme, particularly for Jackson Hewitt. Deteriorating results have created a whole host of problems for Jackson Hewitt. Not only has the profitability of its entire branch network taken a hit, but its operational inefficiency has strained relationships with its franchisees. Franchise offices are substantially more profitable than company-owned offices, and the unwillingness of franchisees to open new locations could force the firm to pick up the slack, which would lead to further pressure on its profitability.

More than an Ordinary Return
Despite the transforming nature of the tax industry and the negative factors that currently accompany it, there is one company we believe could offer great value to an opportunistic investor. We believe the market has penalized H&R Block more severely than is justified. Even with the major concerns permeating the tax preparation market, we believe H&R Block is positioned well enough to survive and continue its market-leading position. Even though the firm has faced some secular and self-inflicted hardships, its return on invested capital has remained robust. Its cash flow also remains extremely strong, and from a valuation perspective we believe it is attractively priced. The stock currently trades at a P/E ratio of approximately 11, while its five-year average has been around 17. Although we don't believe it will be able to materially push Intuit within the software/online industry, it should be able to keep a good portion of clients who would prefer a do-it-yourself option. Its branches are situated in good locations, and the firm has the ability to move the mix of its branch network more toward franchise offices, which should help maintain profitability. H&R Block has also recently refocused its efforts on its core tax services competencies, and the firm has ceased operations in the capital-draining brokerage and mortgage businesses. We find this very positive news, and the nimbleness of its tax preparation business should help it sustain its competitive advantage.

Vishnu Lekraj does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.