Jackson Hewitt Tax Service: Don't Be Fooled Into Thinking It's In Value Territory

Subscribe in a reader

I stumbled upon Jackson Hewitt Tax Services (JTX) during one of my stock screens and had to investigate since it had an eye-popping 0.41 Price to Book (P/B) ratio. As some might know, I try to find profitable companies trading at a P/B of less than one, with the ideal scenario being that they can have all of their Goodwill and Intangibles written off and still have a P/B of less than one.

First, however, a little information on Jackson Hewitt:

Market Cap: $ 84.58 MM
Enterprise Value: $ 412.21 MM
P/E: 4.02
Forward P/E: 4.82
PEG Ratio: 0.82
P/S: 0.41
P/B: 0.41

And Yahoo! Finance description:

[The company] engages in the computerized preparation of federal, state, and local individual income tax returns in the United States. As of April 30, 2009, its network comprised 5,610 franchised offices and 974 company-owned offices. The company was founded in 1985 and is headquartered in Parsippany, New Jersey.

The Surface of Things

Just looking at the above mentioned numbers, JTX looks pretty attractive. Forward P/E and trailing P/E are both low and do not vary significantly, Price to Sales (P/S) is less than one, PEG is less than one and most importantly to me, P/B is less than one, and to boot, very low.

That all being said, even just glancing over the recent news bulletins for this company, and today's stock movement (down 16.5%), suggest that all is not necessarily well in the Jackson Hewitt household. It seems that the big market moving data piece was that JTX was not going to have enough funds to extend profitable tax return loans to customers.

This hits on two levels. The first is that it indicates a lack of cash and a lack of access to credit markets, both issues that are negative. The second, another negative, is that the business will not have access to a profitable fringe line of their business, especially during the most crowded season for individual tax work.

While negative press is something I think an investor should always be aware of, it shouldn't be the most significant factor in selecting an investment. In fact, I'm of the persuasion that oftentimes negative press can expose large amounts of value for investors to capitalize on. That being said, it's time to look under the hood and check out JTX's balance sheet.

For Want of Cash

I mentioned above that the recent negative press on JTX likely spoke to a lack of cash. This is very quickly confirmed after looking at their most recently filed 10-Q from the quarter ended October 31st, 2009, in which one discovers that they only had $60,000 at the end of the quarter. This is likely due to the net loss of $41.3 MM they reported for the quarter, but is still slightly chilling because they borrowed $85 MM under a revolving credit facility.

Now this isn't immediate grounds for dismissal since they've cut Accounts Receivable by 48% from the prior quarter, a positive sign that they're not just making sales on credit to try and boost revenues. Especially since the tax preparations business has seasonal cyclicality (centering around April 15th, the Christmas for the industry), a loss in a quarter that does not include tax season loses some of its significance.

However, after looking farther down the balance sheet, the Goodwill and Other Intangibles jump, since together these make up 85% of the company's total assets. This is somewhat understandable given that companies such as Jackson Hewitt rely on human capital (their accountants) and branding as a means of running their business. You can't really observe the value of these two items on a balance sheet, so when there's an acquisition, the bulk of the recorded assets is going to come in as goodwill.

That being said, compared to H&R Block (HRB), their biggest competitor, JTX's ratio of Goodwill and Intangibles to Total Assets looks absurdly high. H&R Block's Goodwill and Intangibles only make up 25.5% of their total assets, and they're currently sporting a P/B of 6.81. This leads me to think that JTX's low P/B is more of a warning sign than a value investing trigger.

Conclusion

Further examining JTX's balance sheet, if one were to write off all Goodwill and Intangibles the company would be left with a deficit of $304 MM for Shareholder's Equity. Additionally, for Shareholder's Equity to maintain a positive value (i.e. SE is greater than or equal to one), the combination of Goodwill and Intangibles can only withstand a writedown of 40%. To have a P/B of 1 or less, these same areas could only withstand up to a 24% markdown.

Given this information, I can say that I needn't do more analysis as to JTX's future prospects since these items point me to strongly reject JTX as an investment. While if you're the adventurous type JTX might be an interesting roller coaster, I find the risk-reward payoff unsuitable. In this instance, the P/B is probably a signal to look for the life boats on this Titanic.

In addition, one can almost categorically reject service industry investments such as Jackson Hewitt from my value investing perspective when their operational competitiveness is based primarily on human capital. People are the only assets that have legs, and you can bet if things go in to a bankruptcy scenario they're going to try and get out of there. Further, since this stock is going through a flux and the business model seems to be struggling, I'd bet money that JTX's most talented accountants are trying to jump ship, if they haven't already.

To look at the spreadsheet I used for my analysis, please see below
JTX Analysis

The Selection Bias in Goldman's Argument Against the Obama Regulation

Subscribe in a reader

The proposed Obama regulations that I'm referring to are the statements that came out today that he would:

"seek to prevent banks that have special access to low-cost Fed funding from operating or investing in hedge funds, private equity funds, or trading purely for their own benefit in a way that’s unrelated to serving customers." [Bloomberg]

While this is sure to be contentious, I think it's important to take a step back and look at what especially discounted Fed funding is intended for. I'm not talking about the funding that the Fed provides during a "business as usual" scenario, but in scenarios such as this recent credit crisis, when the discount window's possible term length was raised to 90 days and interest rates slashed, the goal was presumably to get some emergency liquidity out there to try and unfreeze credit markets and stimulate lending again.

I won't try to quantify the potential for ruin that hedge funds, private equity, and proprietary trading might potentially represent to a bank, although this is certainly possible. If the goal is to stimulate lending, however, having all these components as parts of banks that have the discount window available to them would make it difficult to monitor where these emergency funds might be going once they leave the Fed. While these other activities no doubt have the potential to be economically important, I don't think there would be significant objection that the Fed's primary objective in a crisis, is to funnel funds to firms that are going to use that money to lend and keep credit flowing, might be hindered if these funds are instead going to any number of other activities available to some of the firms that received emergency Fed funding.

This leads to the Goldman comments coming from Chief Financial Officer David Viniar. He argued:

"If people are focused on things that caused, or were real contributors to the crisis, it wasn’t trading...Most trading results were actually pretty good, not just at Goldman Sachs but at most firms and that’s not really where the problems were." [Bloomberg]

Looking at the results of trading from the crisis as a sample of typical trading is a vivid example of selection bias. It seems that Viniar would like us to think that because most trading was profitable during the crisis, it will be profitable in the future and doesn't doesn't pose systemic risk to banks. While on average trading profits might be positive, that says nothing for the skewness and kurtosis of trading profits/losses. By that I mean that proprietary trading could be negatively skewed or with fat tails (positive kurtosis) in the negative end of the distribution.

This is an example of a positively skewed, positive kurtosis, positive mean distribution. While it will be on average positive most of the time, the long negative tail creates the possibility for financial ruin when returns end up in that part of the distribution.

I'm not going to take sides on this issue, since I can see the validity in both. That being said, I think that Vinair's argument regarding proprietary trading is mistaken. For example, while fund managers can on average beat the market by holding a portfolio of the S&P 500 and writing puts (insurance against a fall) on the S&P 500, when it does go bad, it's ruinous. This is the "picking up nickels in front of a steamroller" scenario.

While I don't claim to know the distribution of trading profits or the absolute level of risk these firms are taking on (they might not know either), I can understand why Obama and his administration would want to prevent artificially-lowered interest rates from fueling these types of activities. Especially since it's meant to stimulate lending, allowing firms that have access to the Fed's discount window to engage in hedge funds, private equity and proprietary trading could be a usage of funds not best for unfreezing financial markets.

That being said, Obama needs to be careful when he talks about "curbing excessive risk taking". Lending to small businesses is one of the riskiest types of loan a consumer bank can do, and since stimulating the flow of credit to areas of the economy such as this seems to be an Obama administration priority, curbing risk taking shouldn't be his goal.

Will the NY Times' Move to Freemium Make a Difference?

Subscribe in a reader

It has come to my attention that the NY Times, a publication I read on a daily basis, but mostly just their blog DealBook, will in 2011 implement a metered system whereby after a certain number of read articles you will be required to register and therefore pay.

Initially when I read this, my first thought was that it might be easy to circumvent a counter if it's tracking an IP by using a proxy. This would be quite hassle, so it'd probably just lead people to finding other mediums to get their information if paying for content is a problem.

Evaluating the decision leads to the general question of which is greater: ad revenue from a freely available Times, or subscription fees from a limited one. Presumably, dropping the current ads the Times has on its website would be a requisite if they were to switch to a freemium model. I know I'd personally be very upset if I were to subscribe and found the website littered with the same amount of ads.

Moreover, I think the concern becomes whether or not people are willing to dramatically change the sources from which they get information, or whether they'll just pony up the additional cash to keep from changing. The promotion of what might be called "new media", sites such as this blog, is a positive externality of publications like the Wall Street Journal, the Financial Times, and the NY Times going to a freemium model. That being said, they also probably won't get as much link traffic since I certainly would never cite something that not everyone could view.

It's somewhat unfortunate that I won't be able to view the Times with the same wanton freeness I used to. However, I'll have no problem substituting in new sources of information. It does, in my opinion, create an opportunity to contemplate the future of "old media" sources like newspapers. I'll be curious to see if the freemium model works.