The Tax Prep Market is going to H&R Block

In the next year, look for H&R Block (HRB)to pulverize its competition for retail tax prep.  Fundamental changes, going on this week, will impact the tax prep marketplace.  It will be one of those disruptive events that should make winners  out of Block, and losers out of Liberty Tax Service and Jackson Hewitt.

The unknown is how JP Morgan will respond.  They are already in the RAL business with a lot of the independents.  Even so, tax season is about two months off.  Can they come to terms with Jackson Hewitt and Liberty Tax?  Can they reach an agreement in time for this year’s tax season?

How RALs Drive Tax Prep Services

The tax prep chains draw in customers based on two things: the quality of their tax prep service, and the availability of advances on expected tax refunds.   In today’s market, tax prepares must provide loans, or really 9 day advances – on tax refunds.  For the kind of consumers that flock to strip-mall tax places, that refund is the payola of the year.  It can often be as much as $2,000 for a family making approximately $40,000 per year.

Refund anticipation loans are a sizeable chunk of income for tax prep chains.  The chains take about 10 percent of the refund.  When the refund comes in, they keep the refund, having already given the tax filer 90 cents on the dollar.  The profits from those loans are divided up between the tax prep company and the partner bank.  In some instances, the bank also provides a service fee to the tax prep franchisee.  The fees are about $3.  That isn’t much, but it provide additional margin.

In some instances, the ral money is the profit, while the tax prep is just a giveaway product.  At Liberty Tax and Jackson Hewitt, RAL profits exceed profits for the entire business.  At Block, it isn’t quite that way, because they charge much lower fees on their RALs, and because they have a side business doing accounting for small businesses.

Block is going to destroy its competition because the other tax prep chains are about to lose their source of money to make those RALs.  Remember that most refunds go out in January and February – as soon as low-income people get their W-2s.  People who pay taxes wait until April 15th. The tax prep chains have to have a lot of cash to cash flow those RALs.  They get that cash from partner banks.  The banks have the cash.

Problem is, only about five banks will do this business.  They are JP Morgan Chase, HSBC, Republic Bank of Kentucky, Pacific Capital Bancorp, and River City (CA) bank.  River City is too small to matter much.  HSBC has a commitment to Block through 2011.  They want to get out of the business, though, and have said it publicly.  Once their contract with Block runs out, they are going to exit.  Chase provides RAL money to independent preparers.  Republic works with the independents, too.

Pacific Capital was the biggest player.  Last year, they processed approximately 3 million RALs and 5.6 million refund anticipation checks.

Long-term, JP Morgan Chase is likely to become the only bank offering these RALs.  It won’t affect their bottom line very much (unlike Block), but they are suddenly the new force for retail tax prep loans.

Pacific Capital’s Fall is the Trigger Event

The big development is that Pacific Capital is about to go out of business.  Today their shares have hit 99 cents.  They are under orders from their regulator, the FDIC, to get more cash on their balance sheets.  They need to get $275 million in new regulatory capital.  Normally, they would do that by selling new shares.  Problem is, their existing market cap is $48 million.  That would dilute their share price to 16 cents.  The SEC won’t allow that.  They could buy deposits, but their credit rating is CAAA1 (Moodys). That is beyond junk.

The takeaway from all of this is that PCBC won’t be able to do the RALs in the spring.  That impacts tax prep chains.  Three banks faciliate RALs for Jackson Hewitt and Liberty Tax: Republic, HSBC, and PCBC.  PCBC has done more than half of all RALs.

PCBC’s Tier One Capital ratio is 5.7 percent. The FDIC wants it up to 9 percent, and they warned them about it in June.  They didn’t get it up after Sep. 30th, so it is possible that the FDIC could come knocking any Friday.

The financial stability of a bank like Pacific Capital was less significant before the credit crisis.  PCBC used to securitize its RAL portfolio.  They couldn’t do that last spring, and it seems hard to believe that something with the huge loss rates (because the IRS doesn’t catch all of the filers with student loan debts or other tax liens) and fraud of RALs will attract new investors in this conservative atmosphere.

Next Question: Who Will Take Pacific Capital’s Place

Who is going to do that business instead?  It is important, because both Liberty and Jackson Hewitt derive all of their profit from these RALs.  At JTX, Ral revenue accounted for 32 percent of all revenue, and amounted to 3 times net income.  They can’t do the RALs without the money, and they can’t get their customers without the RALs.

Republic is under a cease-and-desist order from the FDIC.  They can’t make new commitments to make RALs. They have been allowing a lot of fraud, and the FDIC won’t take it.  So, there’s no new money there.

HSBC is out. They don’t want the reputational risk, and their going to bow out after 2011. River City – too small.  Republic isn’t allowed.  That only leaves Chase.  Chase probably wants the business.  There is one hurdle, though. Jackson Hewitt and Liberty are used to getting a kickback from PCBC on RALs.  For every RAL that those places sell, Pacific Capital has been giving the tax prep franchisees $3.  Chase refuses to do that.

Right now, there are about 60 days before the beginning of the next tax prep season.  No deal has been worked out, and the kickback issue has not been resolved.   Chase is probably going to take this business, but they aren’t in a rush.  As Pacific Capital weakens, their negotiating position with JTX and Liberty is only growing stronger.

That means that Block, as the only tax prep chain that will have RALs in the spring, should take over most of their competitor’s business.  It could be a rout.

The Pacific Capital earnings report came out Tuesday.  This change is fresh right now.

What this means Long-term

It is only a matter of time before the federal government wipes out this business.  That could be accomplished a number of ways.

a) Speed: They are working to speed up returns to just three days.  That would eliminate most of the demand for RALs.

b) Slow down times on the debt indicator.  They could also change how the debt indicator works.  The debt indicators provides the underwriting for these loans.  Banks bring the RAL application to the IRS.  The IRS indicates if the filer has a tax lien of any sort.  They get this back, normally, in twenty-four hours.  That is why there is a one-day turnaround on these loans.  Getting rid of the debt indicator would take an act of Congress.  Slowing down the response time of the debt indicator would only require an administrative change by the IRS.

It also means that Chase is going to have control over this sector. They will be the only bank making these loans.  That hints at the likelihood that they will continue with their policy of not giving a kickback to franchisees. It would be an expression of their market power. They can wait out this tax season.  Doing so would bring JTX and Liberty to their knees.

The other player out there is Wal-Mart.  They don’t make RALs.  They don’t have a bank charter.  That said, they have a contract in place with Jackson Hewitt for in-store tax prep.  That relationship accounts for 12 percent of JTX’s volume. Wal-Mart wants an industrial bank charter.   They have applied for one several times.  Advocates and community bankers have fought that application.  However, the perception of Wal-Mart is changing.  Our economy is suddenly more fond of jobs, and Wal-Mart has addressed some of their corporate social responsibility.  Realistically, the venom that was aimed at Wal-Mart is not the same as it was five years ago.  With a charter, they would be able to challenge Chase.