Focusing on the Business to Save Money

April 21, 2010 by Joe Ponzio

Jackson Hewitt Tax Service (JTX) is the second largest paid individual tax return preparer in the US (based on the number of individual tax returns prepared and filed with the IRS). In 2009, its network of 6,584 offices prepared 2.96 million tax returns. According to Jackson Hewitt, that’s 3-4% of all tax returns prepared by a paid preparer in 2009!

It’s the second largest player in its industry – an industry that deals in one of the two uncomfortable certainties. (Taxes, though we’ll see how death is playing into it too.) And its stock is down 95+%. What’s not to like?

Avoiding Disaster Through Business Investing

If you recall from various past articles (Enron, Lucent, Amylin, to name a few), you can learn a lot about a business and avoid many disasters by focusing on the business instead of the hype and nonsense on Wall Street and in a stock price.

Of course, you can’t avoid every disaster. Still, by focusing on the business and on buying value on the cheap, you can protect yourself from many unrecoverable losses and, perhaps more importantly, know when to get out of an investment that is turning bad.

We lost money on Jackson Hewitt, but not nearly as much as we would have had we been following Wall Street’s advice:

Uncomfortable Certainties

We all know the old saying:

There are only two certainties in life – death and taxes.

Jackson Hewitt is one of those companies that deals in the inevitable – taxes. Though you’re not required to pay a tax preparer to file your return, people generally don’t want to risk an IRS audit and would rather pay someone to “do it right.”

Furthermore, the tax business is a sticky business in that, once you have someone file your taxes, you’re likely to stick with that person or company (for a while, at least) because you fear the IRS and don’t want a new tax preparer/accountant uncovering past mistakes which could cause you financial and legal problems.

A Fast March

As you can see from the chart below, Jackson Hewitt’s stock was on a fast march to nothing. Shortly after the market’s 2007 peak, JTX was changing hands for more than $33 a share. The Great Recession hit, and Jackson Hewitt’s stock was no exception to the market’s decline.

The Panic

In addition to the recession, Jackson Hewitt was facing problems with its Refund Anticipation Loan (RAL) business. RALs are short-term, high-interest loans made to customers that are ultimately paid back by their tax refunds. You may have seen commercials for these – walk in, file your taxes, walk out with a check.

For Jackson Hewitt and the banks originating the RALs, this was a very lucrative and fairly safe proposition, backed the full faith and credit of the US Government (assuming the tax return was okay).

Panic, however, set in for a number of reasons:

  1. JTX was late to the game when it came to online tax preparation software – something its competitors had already done; and,
  2. there was/is a long-standing fear that RALs will be banned by the government; and,
  3. Jackson Hewitt was essentially at the end of its borrowing ability.

Management

As the old saying goes: You want a business that any fool could run because, sooner or later, it will be run by a fool. I won’t go so far as to say that Jackson Hewitt’s management is a bunch of fools; however, they’re not on my favorite list:

They were slow to the online game (you would think that the combination of falling total returns filed and the fact that everything is going online would be a wake-up call).

They borrowed a bunch of money to buy back the company’s stock at highly inflated prices even though the business was deteriorating (are we value investors the only ones looking at the value of the businesses we buy?).

They relied too heavily on a single bank to provide RAL funding…during a banking crisis…in which the bank was severely hammered…to which they turned a blind eye.

The Price vs. Value

At $33, Jackson Hewitt was grossly overpriced relative to its intrinsic value as an ongoing business, and a clear “no thanks” to a value investor. But what about at $4 to $6? A little back-of-the-napkin math would tell you that this is a business that should generate about $80 to $100 million of operating income (excluding depreciation and amortization) under normal conditions. Capital expenditures are small as the company has been focusing on building its franchise business rather than opening company-owned stores; so, $80 to $100 million (call it $90) minus $8 million in normal capital expenditures puts us at about $82 million a year. Lose another $14 million to interest, $27 million to taxes (say, 40%), and you have about $41 million of pre-tax cash flow.

It’s the third quarter of 2009; so, the best information I have is from the latest annual report, in which Jackson Hewitt shows 38,867,231 shares outstanding, less 10,440,491 in treasury (the shares they paid too much for in their buyback program).

At $6 a share (the high end of our buying range), Jackson Hewitt was selling for $170.5 million – barely over four times cash flow. In any book, that’s a bargain and should have plenty of upside potential over the years.

And though I think that management made a number of missteps over the years, the general public knew nothing about this; so, back in July of 2009, there was little reason to believe that the business would fail. People would still file their taxes; and, with Jackson Hewitt rolling out new kiosks in Walmarts and a new online product, I thought, “Okay – maybe they’ll survive. At $4 to $6, it’s looking cheap.”

No RALs? This Could Be Bad!

By mid-December, the bank that had been providing the majority of Jackson Hewitt’s RAL funding was notified that it could no longer engage in RALs until it shored up its own finances. Houston, we have a problem…or is it? (Yes, but I wasn’t sure at the time.)

Shortly after Jackson Hewitt received the news that about 75% of its financial product revenue (a large portion of its total revenue) might be gone, management moved into scramble mode. By the end of December 2009, a silver lining appeared on this otherwise dark cloud:

(Remember: We’re still focusing on the business, not the price of about $4.50.)

Santa Barbara Bank agreed to sell its RAL division to a private equity company, and to complete the sale before the start of the tax season (just a few weeks away). No guarantees; however, the thought process was this:

Why would the private equity company buy the RAL business, and agree to such a quick purchase in time for the tax season, and not fund Jackson Hewitt’s RAL business? After all, Jackson Hewitt is the RAL division’s largest customer by a very wide margin. You don’t typically buy a business with the intention of alienating or denying to work with your largest customer, right?

So…we hold.

Great Thinking…Even Though It’s Wrong!

By mid-January, financing for the RAL product was still nowhere to be found. Jackson Hewitt stated that 50% of its RAL products were funded, but would not identify where or how that count was tabulated. Was it 50% of its most lucrative ones? 50% in number, not quality? I hate shady press releases and filings.

Sometimes you have to go with your gut. In this instance, my gut was telling me that Jackson Hewitt was putting lipstick on a pig, and that the “50%” was not all it cracked up to be. If it was a great 50%, wouldn’t they be parading that on the news?

50% of Something is Better than 100% of Nothing, Right?

In this case, not really. Jackson Hewitt was tiptoeing a fine line. At the end of this month, the company needs to come up with a $25 million debt payment. When I sold out (around $3.50 to $4 per share), what I knew was that Jackson Hewitt was at the end of its borrowing limits, had just $60,000 in cash on hand, had 50% fewer accounts receivable (on 20% lower revenue), and was facing a $25 million cash payment on its borrowing at the end of April.

If it can’t make that $25 million payment, it violates its debt covenants which means it has two choices — close up shop or enter bankruptcy protection. (I don’t know how willing the banks will be to restructure the debt as Jackson Hewitt’s business is declining and it has no net assets to borrow against.)

The Results: Focusing on the Business

In short, Jackson Hewitt was a loser for me. I don’t typically buy with the intention of selling six months later. Instead, I buy with the intention of selling when the price and intrinsic value converge. Though I prefer to see the price rise to a higher intrinsic value, it sometimes happens that the intrinsic value falls when the business deteriorates.

What did I avoid? From $33 to our purchase price ($4 to $6), Jackson Hewitt had fallen about 85%. By focusing on the business, we avoided that.

From when we bought to when we sold, we lost an average of about 16% (using our various purchase and sale prices). And though I’m not crazy about losing money, we avoided another disaster: the ride down from $4 to $1.66 – an additional 59% loss that we didn’t suffer because we focused on the business, not the price.

Everyone takes losses. They happen. Warren Buffett has lost more money than most of us will ever make. You won’t win them all. Still, get back on the horse. So long as you focus on value and making smart decisions, you’ll be quite satisfied with the results.

A Note From Joe Ponzio

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