Friday, June 7, 2013

Does Buying Intuit Make Tactical Sense?

Investing is often about weighing the possibilities of various outcomes and then trying to assign a value to the stock on a balance of probabilities. With Intuit , I think investors are getting a fundamentally cheap company that has disappointed in its core activity this year but is performing very well in its fast-growing non-core businesses. Furthermore the question marks over its core activity (tax returns) won’t be at the forefront of investors’ minds until next year. Time to pick some up?

Intuit explains itself

Having previously been rather positive over its prospects for its core tax-return business this year, the company managed to disappoint the market by announcing that it would only grow 4% this year. This is below the 8-10% analysts had penciled in. For an idea of how important tax returns are to its full year, readers can take a look at the charts in the article linked here.

Naturally, investors will want to focus on why and how its tax-return revenues came in lower than expected. Here are the reasons cited.

  • Overall tax returns were 1% lower this year against Intuit’s previous expectations of 1-2% growth. The IRS has not yet come to a clear conclusion as to why this was so, therefore it would be remiss to expect Intuit to have a clear view either at this time. Obviously this is an industry issue which could normalize in future years.

  • More worrisome, the software category only took 1% market share from manual when it had expected it to come in at 2%. This could be an indication of a slowing of growth in this secular trend or it could be a reflection of issues with Intuit’s software.

  •  Intuit claimed that it didn’t grow its online share as it had expected (although it did well with mobile and retail) and smaller competitors took some share. With 60% of the market Intuit is obviously vulnerable to future erosion. 

In summary, it wasn’t as good as expected. But the reasons for this are a combination of structural and company-specific issues. Nevertheless there were some plus points. Mobile is performing very well and Intuit has clear leadership in developing mobile-app solutions. In addition it is competing well against H & R Block . In addition its main rival reported in its press release that the industry had "experienced unprecedented delays and changes to the timing of taxpayer filings this tax season which created significant challenges."

It then went on to argue that it was essentially flat in terms of overall market share of tax returns. So while H & R Block is pleasing investors because it has managed to fight back against Intuit by developing its own online operations, this is not really a story of Intuit notably losing market share. Moreover if there are some structural reasons why manual tax returns can stabilize their market share then H & R Block is going to be a relative winner out of this.

Intuit's Small Business Group continues to grow

If tax returns disappointed, then there was no such let down with its Small Business Group (SBG) results. This group made up 35% of revenues in 2012 and is growing in the mid-teens. A graphical depiction of its ongoing growth is shown below.

These results have been achieved in an otherwise weak environment for small business and they attest to the cost-effectiveness of their offerings. In addition, Intuit has the capability to cross-sell solutions across its customer base. There is a natural correlation between financial management solutions (QuickBooks, etc.) and HR services

Indeed, this space is getting somewhat more competitive now with Paychex  and Automatic Data Processing chasing growth in order to offset slow growth in their core offerings. I’ve discussed these companies in more detail in an article linked here.  Paychex’s payroll service market is only growing in low single digits but its human resources services operations are growing in double digits. Paychex's key attraction is its dividend yield, and even though it has more limited pricing power than in previous recoveries, it still has upside from the jobs recovery working its way down into small businesses. Meanwhile ADP’s growth prospects come from its professional employer organization services group. The environment is clearly getting more competitive, but for now Intuit is performing well.

Where next for Intuit?

I think investors need to keep things in perspective here. Intuit is a huge cash generator and is on a good cash-flow yield. This hasn’t been a good year for its core tax revenues but it still recorded 4% growth while growing its SBG in the mid teens. If it only replicates this performance next year, then I think the stock is a good value. Indeed, there is some upside potential from some of the structural issues (falling tax returns) being resolved.

By my calculations Intuit has generated over $1.2B in free cash flow on a trailing year basis and as I write. That puts the stock on a free-cash-flow yield of 6.8%. In other words, if you buy the stock now and it keeps generating this kind of cash then in 14 years (and this is conservatively assuming no real growth) it will have generated its evaluation in cash. I think that is attractive for a business that – despite slowing growth in its core activity – is still capable of revenue growth in the high single digits.  In addition, the market's focus is largely going to be on its SBG until the next tax season comes around.

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