Skip to Content
Stock Strategist

Taxing Times for H&R Block

Our new moat rating reflects a fundamental shift in the tax prep business.

Mentioned: ,

The personal services industry encompasses an array of industries. Under this grouping, we include firms that provide services to consumers, but do not seem to fit the traditional mold of consumer-related names. In this article, we are going to focus on the tax preparation services industry.

As the U.S. tax season winds down, millions of Americans have prepared and sent their returns to the IRS. In the past, the daunting task of filing a tax return motivated many taxpayers to seek professional assistance. Tax filers discovered that the convenience and peace of mind that these tax preparation firms offered them was well worth the few hundred dollars they charged for their services. Thus, tax preparers such as  H&R Block (HRB) and  Jackson Hewitt (JTX) thrived with solid market share, robust revenue growth, and enviable operating margins. However, these results have changed since the early part of the 2000s, with greater competition from traditional and nontraditional players alike.

Both Jackson Hewitt and H&R Block have seen their market shares decline, their revenue growth rates slow, and their operating margins compress over the last handful of tax seasons. We believe the retail tax preparation industry has changed permanently. These changes were ushered in with the advent of do-it-yourself (DIY) software and online tax preparation services, increased competition from other brick & mortar establishments, and managerial missteps. This dynamic is especially troubling for the industry's stalwart player, H&R Block. We had believed the firm possessed a wide economic moat. However, we have recently adjusted our analysis. We believe it is no longer a wide-moat firm. Below, we examine the evidence and offer our rationale for our moat rating downgrade.

Managerial Missteps
In 1997 and 1999, H&R Block acquired Option One Mortgage and Olde Financial, respectively. These were the first in a series of steps that ultimately impaired H&R Block's operations. In order to seek growth and profit expansion, the firm's former management team sought to provide other financial services to potential customers. This strategic shift was harmful to the firm's entire operations. Not only did it sustain deep loses from these new ventures, but the firm also lost market share within its core retail tax preparation market, as it shifted its focus away from its main operations.

Most notably, H&R Block recently faced the issue of its fairly large book of subprime mortgages. During the housing and mortgage boom, the firm sought to increase revenue and profit through underwriting and selling subprime mortgages. As the housing crisis worsened, the value of the firm's mortgage book declined, and it sustained heavy losses.

The Proliferation of DIY Services
DIY services have been growing in acceptance among the retail tax preparation customer base. The advent of these services has changed the competitive dynamics within the retail tax preparation market. These services are priced significantly lower than traditional branch tax services, and the value proposition is very compelling to consumers. We believe that DIY products have demystified the tax preparation process, and have also created greater pricing sensitivity among U.S. taxpayers. The growing price sensitivity shown by the retail tax customer will not dissipate, in our opinion, and the price point of H&R Block's traditional branch services may be too aggressive given the shifting market.

The main beneficiary of the DIY trend has been software developer  Intuit (INTU), which dominates this niche with its TurboTax product. The firm was the first to offer such a service, and has benefited from a first mover advantage. H&R Block and other traditional retail tax preparation servicers were initially very resistant to offer DIY services, and viewed them as competition. However, the adoption rate of these services among consumers has steadily increased, and most major tax preparation players have been forced to offer some sort of DIY product. H&R Block recently started to fully embrace these services (even though they have offered a DIY product since 1993), and is the second largest DIY service provider. However, through the first half of the 2010 tax season, the firm has actually lost market share within the DIY market niche despite its stronger push within this space. Year-over-year, H&R Block has witnessed the number of its DIY products sold decline 2% while Intuit has seen its product increase 11% through February 15th 2010.

Below is a graph that shows the number of DIY units sold, beginning in 2003. Intuit has grown its lead over H&R Block substantially over the last three tax seasons, and 2010 doesn't look to be any better. This trend is especially concerning to us. If H&R Block continues to lose share within this space, its competitive position will erode at an increasing rate. The chart below shows the trend in DIY units sold through 2009.

 

 

H&R Block Faces Greater Competition
H&R Block has not only faced competition from DIY services, but from other smaller tax preparation shops as well. Many cash advance and payday lender operations offer tax preparation services as well. These firms have taken advantage of H&R Block's past strategic missteps, and have undercut the firm on price. One of the primary beneficiaries of H&R Block's misfortunes has been privately held Liberty Tax. Liberty Tax was founded by former Jackson Hewitt CEO and founder John Hewitt, and currently boasts a branch network of approximately 3,300 offices. Starting from a small base, Liberty tax has grown its operations dramatically over the last few years and, according to the firm, has also stolen market share from the traditional branch tax preparation servicers.

Even with the increased competition, there has been one positive factor working in H&R Block's favor. Its major rival, Jackson Hewitt, has faced even bigger problems. The total number of returns processed by Hewitt has declined faster than it has at H&R Block. The firm has also faced significant funding problems for its Refund Anticipation Loan (RAL) product. RAL products are key to Hewitt's operations, and its inability to provide these products would be detrimental to its competitive position. We previously believed this dynamic would provide H&R Block with an excellent opportunity to steal market share. However, this has not been the case. Through the first half of the 2010 tax season, H&R Block's slide in market share has actually accelerated. The only publicly-traded tax preparation industry player that has grown its market share (and also its competitive position) has been Intuit. The chart below demonstrates results through 2009. We have applied the number of returns processed and DIY units sold to estimate market share. As a result, it should be noted that Intuit's share might be slightly understated. To give an example, if a married couple filing separately used H&R Block's branches, that would count as two returns processed. Alternatively, if this couple purchased TurboTax, that would only count as one unit sold.

Accelerating Market Share Loss in 2010
H&R Block has lost market share over the last few tax seasons. We previously expected results to stabilize this tax season, given the extreme headwinds facing Jackson Hewitt and management's new strategic shift toward a greater emphasis on Block's DIY TaxCut product. However the number of tax returns processed by H&R Block through the first half of the 2010 tax season has declined 6.3%. This has occurred despite an expectation that the total number of U.S. retail tax filings will decrease only about 1% to 2% for the 2010 tax season, due to a weak employment market. Combining this decrease with Intuit's gains so far this year leads us to believe H&R Block will end up with an acceleration in market share loss in 2010. Even if the firm is able to grow its share over the next few years, we believe the long-term secular DIY trend will eventually erode its position. Even though the firm is still the second largest player within the DIY market, we believe Intuit will garner the majority of the benefit.

H&R Block's Profitability Could Be Impaired
Pricing for DIY products is significantly less than that of traditional branch-assisted services. This, coupled with increased competition from other "mom & pop" shops, will impair the premium that H&R Block can charge, in our opinion. The price a customer pays to use a DIY product typically ranges between $20 and $40, and the price that same customer pays to utilize H&R Block's traditional branch services can extend over $150. We believe a mix shift will occur, lowering the blended price paid by H&R Block's customers over the long term. Additionally, in order to just preserve its current customer base, the firm may need to use discounting in the future.

The preservation of the firm's customer base may also mean it will not be able to adjust its cost basis with a declining blended price per return. The firm will need to maintain its current branch network, and may need to increase marketing and sales expenses in order to stabilize its position. This leads us to believe that a return to previous levels of profitability is unlikely.

Conclusion
Given the confluence of these factors, we believe H&R Block faces severe headwinds, and that and the long term prospects of traditional branch-assisted tax preparation services are negative. At best, the market for such services will remain flat over the medium term, in our opinion. Given the trend towards DIY services and growing competition from larger players such as Liberty Tax and smaller "mom & pop" servicers, we believe H&R Block will face a tougher operating environment for its core branch service. We also believe that Intuit will continue to grow its share of the total tax preparation market, and will continue to expand its dominance within the DIY market. H&R Block's profits, growth potential, and ultimately its returns on invested capital, will be pressured over the long term in our opinion. Therefore we have downgraded our moat rating to narrow.

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