H.R. Block's Daunting Bottom Line

As H&R Block copes with shrunken earnings, adverse publicity, and Eliot Spitzer, Intuit's TurboTax program is coming on strong

Shannon Graham was daunted. She had just turned 18, was living on a U.S. military base abroad, and had to file her own income taxes for the first time. Luckily -- she thought at the time -- there was an H&R Block right on the base. It turned out to be not so fortunate: Her taxes never got filed and she ended up in hot water with the IRS.

Five years later, out of the military and back in the U.S., she was filing her first taxes as the owner of a home day-care business. Again intimidated, she went back to H&R Block (HRB). Again her taxes came out wrong.


  Not only did she vow never to return to the ubiquitous strip-mall tax chain, but she decided to go to school to become an accountant. "I finally figured it would be better if I had some knowledge of what I was doing," she says. In this, her third year of accounting school, she finally had the confidence to do her taxes by herself -- with the help of TurboTax, a tax-preparation software sold by Intuit (INTU). "I couldn't be happier," she says. "Everything was done so correctly and so easily."

Graham's switch underscores the rising stakes in a struggle between Intuit and H&R Block for prime position in the $20 billion market for tax-preparation software and services. And with the Apr. 15 tax-filing deadline weeks away, the battle is reaching the most critical stage of the season.

For now, Intuit may have the upper hand. After years of losing about as many customers as it gained, Intuit had a banner tax season in 2005, partly because it made products easier to use. Intuit's consumer tax business grabbed market share from H&R Block's competing product, TaxCut, and almost singlehandedly saved the company from what analysts said would be its first year of less than 10% growth -- a kiss of death for a software stock.


  Performance was so hot that then-head of the TurboTax division, Brad Smith, was promoted to head of QuickBooks -- the biggest job in the company after CEO (see BW Online, 4/22/06, "How Intuit Quickened Sales").

This year has begun on a strong note, too. On Mar. 9, Intuit raised its forecast for third-quarter sales. The company now expects revenue of $880 million to $900 million, or growth of 5% to 8%, vs. an earlier forecast for 3% to 5%. Sales at the consumer-tax group are expected to rise 12% to 15%, compared with earlier guidance for growth of 10% to 12%.

"The tax season is turning out better than we expected," Intuit Chief Executive Steve Bennett said at the time. As of Mar. 9, TurboTax unit shipments, which include retail and online sales and software giveaways through the Internal Revenue Service, were up 16% over last year.


  Meantime, H&R Block is stumbling. Embarrassingly, the company has been forced to restate earnings after misfiling its own taxes -- owing the IRS some $32 million in back taxes.

Adding to Block's woes, it's under investigation by New York Attorney General Eliot Spitzer for fraudulently pushing hundreds of thousands of low income customers into its Express IRA Product (see BW Online, 3/16/06, "It's Taxing Times for H&R Block"). Results aren't looking too hot. In the most recent quarter, net earnings fell 69%, to $28.8 million.


  Intuit's TurboTax is the brand of choice for people who feel confident enough to do taxes themselves. According to H&R Block, that's at best 40% of a market that includes some 140 million filers. H&R Block is often the default for people who need more hand-holding. But for both, it's not enough just to defend home turf. The annual growth in tax filers is at most a paltry 2%. So the two are in the unenviable position of shoring up an existing base, slogging it out for a small pool of new customers -- and increasingly encroaching on each other's territory.

For Intuit, that means forays into the service side of tax preparation. There are no plans for an expensive brick-and-mortar TurboTax chain. But this year for the first time, the company is piloting a project where accountants offer live chats when people get stuck. The accountants will review and certify a filing, giving a reluctant do-it-yourselfer some peace of mind.

Brad Henske, head of Intuit's consumer tax business, says it's a more cost-effective way to offer tax services, since there's no store overhead and accountants can work remotely anywhere in the world.


  It's too early to tell how well this is resonating with customers, although Henske is upbeat. A big clue will be whether TurboTax features the service more prominently next year or raises the $99 experimental price it has now.

For its part, H&R Block is getting more serious about its TaxCut software, a product that's done little in the market since it was launched in the mid-1990s. That's partly because Block isn't a software company and partly due to formidable competition from Intuit. Even in Intuit's less-vigorous growth periods, it has maintained a lock on the software market, thanks to brand-name recognition, word of mouth, and millions of dollars invested in watching everyday people use its software and polling them for likes and dislikes.

Unlike many Silicon Valley software companies, Intuit is run more like a consumer product company. "We clearly build a better software product," Henske says confidently. Analysts agree, "No one understands what their customers really want more than Intuit," says AMR Research analyst Bruce Richardson. He doesn't expect them to be dislodged any time soon.


  But Block isn't standing idle. Last year, it acquired a small tax software startup TaxNet, including its founder, Tom Allanson. TaxNet only operated for one full tax season, but Allanson says it prepared some 130,000 returns. While the bulk of TurboTax customers buy the software in retail stores, TaxNet was from the start an Internet application. And before starting TaxNet, Allanson was head of Intuit's consumer tax business.

Finally, Block has someone who knows the software business and, more importantly, knows the enemy.

While at Intuit, Allanson was among the critics that chided H&R Block for its lack of innovation. But he says that's changing now.


  Block is beefing up its online product and working harder to push it to the entire customer base, lest it lose emboldened do-it-yourselfers to Intuit. Intuit continues to draw most of its revenues from shrink-wrapped software, although it's online business is growing, up 58% so far in 2006. "Block has the resources and now they have the expertise," Allanson says.

Allanson is already making his mark. He's eliminated confusing branding of the software and online versions of TaxCut, rolling them into the same name. That has let the company pursue an advertising campaign that pushes a single brand. Allanson says last year's marketing budget was doubled. He's also overhauled the way the product looks and feels.

And the company is being much more aggressive on pricing, offering rebates and specials in stores. Beyond that, Allanson won't comment much on plans to overtake his former employer. One of his few clues: "It isn't really about this year," he says.


  As Graham's story shows, both companies have perceptions problems to overcome if they have a hope of significantly expanding their customer base. The obvious challenge for Block is overcoming doubt from customers like Graham who have been burned -- and indeed the stigma of getting its own taxes wrong. Investors won't know how big an impact the snafu has had until tax season ends, but already shares are off nearly 17% since the news came out.

But Intuit too has a perception problem. Even though Graham got burned by Block once, she went back. Similarly, she says many of her friends go to H&R Block, "even though they feel like they're getting ripped off."

Why? It's easy and cheaper than standard accountants, and you can blame someone else if your taxes turn out wrong.


  Graham was persuaded by an Intuit commercial that hammered home the message that its software could hand-hold worried filers. But that wasn't until after two bad experiences at Block and three years of accounting school.

With loyalty like that, Block may yet bounce back. And future tax-season battles may be decided as much by marketing and word of mouth as by products and advice.

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