Jackson Hewitt: Taxes at a Discount

Despite much uncertainty in the markets, I bought Jackson Hewitt Tax Service Inc (JTX) at $23.87 Friday. Jackson Hewitt Tax Service is a classic example of a good company in a solid business with great growth prospects currently trading at a discount.

Why is JTX trading at levels not seen since mid 2005, despite good year-over-year earnings growth? Three are four good reasons:

1. A Jackson Hewitt franchisee got into some hot water early last year for messing with the IRS by filing bogus tax returns. (However, the Justice Department law suit alleged misdoing by only 125 Jackson Hewitt franchised locations out of the almost 5,800 and it was settled with no payment from the company.)

2. The IRS decided to take a stab at the rebate anticipation loan business that Jackson Hewitt participates in and derives revenue from by referring their tax preparation clients to financial institutions that do the actual lending. (However, the IRS did not actually do anything to ban the practice, they have only announced that they may want to regulate these types of loans starting in 2009.)

3. The tax preparation business is very seasonal, so Jackson Hewitt (along with just about any other tax preparer) has two quarters of losses every year and their Q2 (last completed quarter of operations August - October 2007) is always the worst.

4. Market players are very nervous these days and tend to overreact to any news that could be perceived as negative.

So why is JTX a good buy at the current price?

Five big reasons reasons:

1. Death and taxes are two things that humans have tried to unsuccessfully avoid since time immemorial – and have always failed. US Congress has attempted to simplify tax code more than once, but have only made it more difficult every time. As a result most everyone in the US needs the help of tax software or tax people to get their taxes done.

2. The #1 tax preparer H&R Block (HRB) is bidding for market share among do-it-yourselfers with a massive TV advertising campaign featuring their Tax Cut software “backed up by people." While Jackson Hewitt targets lower middle class filers by placing most of their small footprint office locations inside Wal-Mart stores and in walk / drive up strip malls, strategically chosen to be in working class neighborhoods. JTX customers are more likely to have simple tax returns that they would rather shell out $50 - $150 for somebody else to do, than attempt to figure out how to do it themselves, software or not. H&R Block ads only serve to remind them of the nearing tax deadline and prod potential Jackson Hewitt customers to get their taxes done next time they go shopping at Wal-Mart (WMT) or grab a ½ gallon of milk at their neighborhood convenience store.

3. Jackson Hewitt has a great business model! The company gets revenue from the franchisees no matter what happens. Yet it spends considerably less on corporate advertising than H&R Block, relying on location to generate plenty of foot traffic. And there is no software and no associated expense for maintaining, updating and supporting it. Remember that H&R Block has several versions of online and off-line Federal tax software to support as well all the state programs. They compete with the likes of Quicken on the consumer high end, as well as with Tax Act on the low end, which gives away their Federal tax software for free. Not to mention that there is FreeFile for the $94 million filers who earn $54,000 or less.

4. Jackson Hewitt sticks to what they know (and they know it well) – taxes, unlike H&R Block, which wasted more precious resources on an unsuccessful attempt to expand into subprime lending.

5. While Jackson Hewitt is the second largest tax preparer in the U.S, it only has 4% of the market and is positioned well for growing that market with new filers, as well as at the expense of the many mom & pop shops that often close down as their owners retire. (Of course this last statement doesn’t apply to my cousin and his wife in Albany, New York who will grow their tax preparation business to compete with Jackson Hewitt before they retire!)

Big thanks goes out to Vitaliy Katsenelson, personally and ContrarianEdge.com website for turning me on to Jackson Hewitt and doing much substantial research on the company.

Disclosure: Author has a long position in JTX

Comments

[Alex Garcia:]

so what do you think its worth?

2008 Jan 27 08:48 AM

[Jake Berzon:]

Alex,

The stock is only worth as much as somebody is willing to pay for it and that depends on the market in general, as much as it does on the company itself. Today, this company's stock is distressed and the market players are jittery, therefore JTX is worth $24/share. Under normal market conditions, this stock would be worth around $30 / share now, which is the price I expect to fetch for it within 6 months.

2008 Jan 27 11:15 AM

[valueman:]

I follow this company closely, and I think you are very much under-estimating the IRS's intentions and willingness to eliminate tax preparer's ability to profit from RALs. It is important to understand that the IRS has no regulatory ability to end RALs, but they do have the ability to prevent tax preparers from profitting from the marketing of RALs.

If JTX loses its ability to profit from marketing of RALs, this stock is worth $15/shr. And if IRS does nothing, it is worth $40/shr. I have no idea how to handicap what the IRS will decide, but they are not starting the rulemaking process simply to fire a shot accross the bow, as several analysts have stated.

2008 Jan 27 07:05 PM

[Jake Berzon:]

ValAd, You are correct to say that if RAL income was to go away, JTX would loose a significant profit source. But please keep in mind that IRS is only in business of maximizing tax revenues for the government. They are not in the business of legislating how business is to be conducted. It would appear that IRS has no jurisdiction over the RAL issue. In any case, if the IRS concerns are alleviated through industry action (and I expect that they will be) over the next year, this issue will go away all by itself.

2008 Jan 28 01:59 AM

[valueman:]

I agree that IRS has no direct jurisdiction over RALs but they absolutely have jurisdiction over tax preparers with respect to RALs. They have jurisdiction because they have jurisdiction over anything that affects tax returns. And agency lawbooks are filled with court decisions that give every shadow of a doubt to the beauracrats. If the IRS says that mixing RALs and tax preparation raise fraudulent returns, that is good enough. Proof not required. Justice Scalia would have it very differently, but his view has not prevailed since pre-FDR. I am very confident that if the IRS wants to eliminate tax preparers from profiting from RALs, it can do so and no court would overrule that action.

I am not sure I agree with the simple motive you assign to the IRS. My observations regarding government agencies are that their actions are driven by much more complex motivations.

It is well known that there are several legislators who want to eliminate RALs. Their method was going to be to prevent lenders from finding out if the tax payer has any outstanding liens. By withholding that info, the risk of the loan would skyrocket and cause big troubles for RALs. It is quite possible that a legislator has encouraged this action from the IRS since they could not get legislation passed. It would not be the first time that a legislator has used executive branch action to accomplish what could not be passed under law.

My main point is that this stock is trading at $22 not because of franchise troubles (that issue was resolved favorably) or because of seasonality or because the market does not appreciate the strength of its business model. The only first-order factor in the case of JTX is whether IRS kills the business model. And I think the belief that the IRS will almost certainly not eliminate the biz model is just wrong. How often do we see govenment agencies (especially the IRS) start the formal rulemaking process without a serious intention to consider the rule? If the IRS had simply wanted to send a shot across the bow, there are much easier and less formal ways to accomplish this. My sense is that the IRS reallly wants to consider it and really wants feedback.

I think the industry has a strong argument against the proposal as outlined by JTX. Namely, the IRS cannot eliminate RALs and if tax preparers cannot be involved, payday lenders will enter the field and the practices will be even more abusive. I believe this argument carries a lot of weight.

I think the probaility IRS eliminates tax preparer/RAL connection is 50%-ish. Are you saying you think it is <10%? I'd say mkt is implying about a 65% right now with stock at 22.

2008 Jan 31 12:06 AM

[Jake Berzon:]

I really think that the market is scared silly of just about anything right now and any potentially negative news is getting interpreted and acted upon 3 x the magnitude of what it normally would be. In the case of JTX, what you are interpreting as a 65% chance of an end to the RAL business, I see as the market overreacting to a small chance of this happening.

Why do I think that it will not happen? The reason that RALs exist, is because there is a real need for them. IRS will not be able to stop RALs, without first eliminating a need for them. (Which they can do eventually, but not for a very, very long time.) In the meantime, I think, they will quickly figure out that other alternatives that RAL getters would be forced into will be even worse and their attempt to stop the practice would only hurt those that they are trying to protect.

Of course, I could be wrong and IRS could act irrationally. It wouldn't be the first time they did that, but I have faith! In any case, the downward risk is far smaller than the appreciation potential at this point.

2008 Jan 31 03:51 PM

[User 177145:]

You are all wrong. JTX dropped below all your expectations. With the amount of heat they got last year due to there unprofessional experiences, who's dumb enough to buy? There fee's were also high. With the emergence of all these mom and pops stores that are doing simple tax returns for $25-$35, they are literally choking them out. Jackson Hewitt charges atleast $75-$100 for a simple return.
It's even worse that the market is terrible. Even with the Economic Stimulus Plan that Bush passed (which will cause people to file who usually arent required to file), JTX will still fall , even before the season ends. So, stay away from JTX. Stay far, far away.

2008 Apr 12 10:07 AM

[Jake Berzon:]

User 177145, you were correct to point out that I was too early jumping into this stock and that it made a bottom much lower than I was anticipating. However, it has already recovered more than 20% over the past two weeks since you made your post.

JTX remains in a strong position and is a valuable franchise. The company made some mistakes, which I did not anticipate and it quickly paid for them with a lower stock price. Those problems were temporary and are behind us now.

As inflation picks up further many of the mom and pop shops will be driven out of business or will be forced to raise prices. JTX input costs, on the other hand, will not change significantly and they will be in a great position to gain market share.

Unless management makes some bad mistakes or the US economy collapses completely, this stock should double from here by next summer.

2008 Apr 30 03:11 PM