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AMM Dividend Letter 41: How Brewing Beer is Like Investing and Intuit (INTU)
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AMM Dividend Letter 41 How Brewing Beer is Like Investing and Intuit (PDF)
Episode Transcript
Welcome to the 4th episode of the AMM Dividend Growth Podcast. I’m Glenn Busch a portfolio manager with American Money Management. In each podcast episode, I discuss a current holding in our dividend growth strategy. Today’s episode is all about Intuit.
Intuit is another new dividend payer and I’ll get into its dividend history, safety, the catalysts for future price appreciation and dividend growth, the risks to our investment, and our estimate of fair value.
For the full show notes, transcript, and a link to the full Intuit Dividend Letter, there is a link in the description or head to www.amminvest.com/episode4
Before we get going I need to read you our disclaimer.
Before we get into Intuit I want to clarify the schedule and timing of this podcast. The order of events is I write the AMM Dividend Letter. Then about a week later, I convert that write-up into a podcast episode. Then hopefully a week or two after that I convert it into a video that’s published on YouTube.
My goal is to have a new dividend letter go out once a month and to release a podcast episode once a month. Life gets in the way and you combined that with a little writer’s block and the Intuit letter kept getting pushed back.
I would like to give you a new episode every month but don’t be surprised if from time to time it takes longer than a month for a new episode to come out.
With that out of the way let’s dive into Intuit.
Intuit is probably most known for its Turbo Tax business. Which was created by Chip Set a San Diego company that Intuit bought.
Turbo Tax is an extremely profitable business. I’ll spend some time talking about Turbo Tax but the real opportunity we see is with Intuit’s QuickBooks Online business or QBO for short.
We classify Intuit as a new dividend payer. I know, I know, every stock mentioned in this podcast so far is a new dividend payer. We do own dividend stalwarts. I swear. The problem is they were the subjects of our earlier letters and we just started this podcast. The next episode should be about a dividend stalwart so be on the lookout for that one in a month or so.
Intuit started paying a dividend near the end of 2011. That first dividend was $0.15 per share on a per quarter basis. Intuit’s most recent quarterly dividend was $0.47 per share. That’s a compound annual growth rate of 16.2%.
Intuit’s dividend is also very well covered.
Its payout ratio is 34.3% which is well below our 60% cut off.
Its cash dividend payout ratio is 25.7%. Also below our 60% cut off.
Free Cash Flow to Equity Coverage is at 247%. Well above the 100% we want.
Debt to Equity is 0.2. We’re looking for less than 1 here.
And Intuit’s interest coverage ratio is 99.05. Well above 2 times.
Given Intuit’s coverage ratios, low payout ratios, high returns on invested capital, we think Intuit can continue to grow its dividend at double digits rates for at least the next few years or more.
As I mentioned earlier we think QuickBooks Online is Intuit’s big opportunity for growth and a big opportunity to build another economic moat. Turbo Tax already has one.
You might remember Quicken Software. It was Intuit’s personal budgeting software before it bought Mint.com.
Intuit learned that small business owners were running their business accounting and inventory management through Quicken. Quicken was not designed to handle the cash flow management of a business.
So Intuit built QuickBooks. QuickBooks was like every other software. Intuit would launch a new version. Then over the next few years improve the software and launch the updated version. They would then hope new businesses and existing businesses would buy the updated version.
Intuit is not afraid to reinvent itself and they are trying to do so again by shifting QuickBooks from the old Desktop software model to a Software as a Service Model.
This switch to a SaaS model will help Intuit build an economic moat around its business through increased switching costs and Network Effects.
Switching costs are the costs to switch from one product or service to another. The costs can be monetary, they can be time based, and most likely its a combination of both.
For software companies the major switching costs are the Data Trap and the Learning Curve Trap.
The standard example for the Data Trap is Apple’s iTunes ecosystem. You purchased movies, music, and apps that only work with Apple products. If you leave you the Apple ecosystem you would have to repurchase everything. The data you own is trapped on their ecosystem.
Now, the data you generate on QBO is your data. You’re free to move it to wherever you like but this comes with risks. It is very time consuming to move your data and if you need to hire a data transition team the process can be costly.
It’s also risky.
Data sounds ubiquitous and that it should be easily transferrable across all systems. But it’s not.
Different systems have different formatting.
The data you’ve built up on one platform may not match the formatting of the new system. Fixing the errors and reformatting the data is time consuming and there’s a big risk you could lose some of your data during the transfer process.
To move to a new software system it must be worth the risk. Usually it isn’t and customers stay on the old platform.
The second switching cost is the Learning Curve Trap.
Once you’ve learned how to use a software program you’re unlikely to switch to a new system because you don’t want to learn something new. We’re all the old dog with new tricks.
If you own a business and the more people that you’ve trained on the old software, the harder and costlier it is to retrain everybody. Your old software system has to be incredibly bad to force the change.
If QBO is the first accounting software a business uses then it is unlikely that the business will move away from QBO. The experience with QBO would have to be really bad to force a move.
QuickBooks Online also has potential network effects.
Without proper accounting and cash flow management your business won’t last long. Even if you have a great product or service. Cash flow management is the most cited reason as to why a small business failed.
Most business owners aren’t accountants so they hire a small business accountant to manage their books. This is QuickBooks Online two sided network effect opportunity.
A two sided network is one where the usage by one set of users increases the value for another set of users. Über is a good example. The more riders on its platform increases the value of the Über platform for the drivers. And vice versa.
The more small businesses that use QBO the more attractive it is for small businesses accountants to use QuickBooks Online. And the more small business accountants that use QBO the more likely small businesses will use QBO.
With QBO being an online service, an accountant can access their clients’ books remotely. This frees up the accountants time. They can handle more clients and grow their business.
If a small business hires an accountant that uses QBO then the business is more likely to subscribe to QBO.
This is from Neil Williams at the Bank of America Global Tech Conference June 7, 2017.
The most significant one right now is really working with your accountant and we know that if an accountant switches their practice to QBO, they’ll bring their clients along with them and they’ll help the client in the transition. So that’s the big idea we’ve been working on for the last year or so, but I think it’s going to be pretty steady for a while.
QuickBooks Online is also building an indirect network effect.
An indirect network effect is when the increased usage of one product spawns the production of increasingly valuable complimentary goods that in-turn increases the value of the original product.
QBO is an open platform.
Other companies can build and integrate their software with it. For exmaple, QBO has its own payroll and payment processing applications but it doesn’t block others. Intuit allows ADP, PayPal, Square, and others to integrate their payment and payroll processing with QBO. An open platform allows Intuit’s customers to continue to use their favorite non-QBO software while remaining in the QBO ecosystem. The more 3rd party software integrations with QBO, the more valuable QBO becomes to its current customers and potential customers.
Right now QBO’s biggest threat is not the other accounting software programs like FreshBooks or Xero. The biggest threat is Excel.
According to Intuit’s management, over 80% of small businesses in the U.S. run their accounting through a spreadsheet.
Spreadsheets are cheap. Most people know the basics and if you want to improve your skills there are a bunch free tutorials online. But running your cash flow through a spreadsheet comes with big risks.
Spreadsheets are costly in terms of man hours spent updating and maintaining them.
It is easy to make a mistake when inputting your data that can have big consequences.
JP Morgan Chase lost over $2 billion due to a spreadsheet error. A small entry mistakes can compound into big problems as your spreadsheet uses that error to perform the rest of its calculations.
Another issues with spreadsheets is you’ll end up with dueling spreadsheets. Some employees are working on the budget and others are working on inventory management. Then the two spreadsheets have to be reconciled and the data from one group might have to be re-entered increasing the odds for more errors. Running multiple spreadsheets makes tracking down the error even harder.
Lastly, spreadsheets don’t scale with your business.
The $20-50 per month for a dedicated accounting software solution is a small cost relative to the immense benefits it provides.
There are around 48 million small businesses in the U.S. and currently QuickBooks Online has 2.59 million U.S. subscribers. This is a 5.40 percent market share. QBO also operates in the U.K., Australia, and Canada.
Given the benefits of a dedicated scalable accounting software program and the wider adoption of software as a service, QBO’s market share should continue to grow.
The net growth (business formation less closures) of small businesses tends to follow economic growth. In the U.S and Australia this equates to a long-term small business growth rate of 3 percent per year. In Canada it’s about 1 percent. The UK growth runs around 2 percent.
If QBO reached a 15 percent market share in 10 years in each of its 4 markets this would be a 13 percent compound annual subscriber growth rate.
At a 25 percent market share, it would be an 18 percent compound annual growth rate for QBO subscribers.
Small business growth will not grow at 3 percent per year. Small business formation growth is lumpy. We’re just building out a simple base line for potential growth.
Also, these estimates don’t account for Intuit’s efforts to expand QBO into other countries like France and Brazil.
In its most recent quarter QBO recorded a 32 percent year-over-year subscriber growth rate and a 7.7 percent sequential growth rate.
QuickBooks Online is the leading small business accounting software with limited competition. We think 25% market share is an obtainable goal.
Besides a high growth rate some other key SaaS metrics are:
Retention rate
Churn rate and its reciprocal Customer Life Span
Customer Acquisition Costs (CAC)
Lifetime Value per Customer (LTV)
And LTV-CAC ratioIntuit reports its QBO retention rate at 82 percent. The churn rate is 1 minus the Retention Rate which we calculate at 18 percent. The lowest QBO’s churn rate could possibly get is 15 percent given how many small business close each year. To get the average customer life span we take the reciprocal of the churn rate which is of 5.56 years.
QBO’s worldwide Average Revenue per User is $338. The simplest way to get Lifetime Value is to take ARPU and multiply it by the average lifespan per customer. At the end of the most recent quarter QBO’s simple LTV is $1,878.
The traditional way to calculate LTV is to account for the retention rate, the gross margin per customer, and Intuit’s weighted average cost of capital (WACC). Using the traditional LTV model each customer is worth $5,283.
Intuit does not break out its customer acquisition cost (CAC) but it does report its LTV-CAC. As of the most recent quarter that ratio is 4.5.
A LTV-CAC greater than 3 is considered above average. At 4.5x Inuit can afford to spend a little more on acquiring customers now to generate higher growth and increase the present value of QBO.
In the full Intuit Dividend Letter there is a table with all these key SaaS metrics for the last few quarters. Again, there is a link to the full letter in the description.
We can’t talk about Intuit without talking about Turbo Tax.
Turbo Tax is synonymous with do it yourself taxes. Like QBO, Intuit has built a business moat around Turbo Tax through the Data Trap. The initial hurdle is to get someone to try Turbo Tax for the first time. After that initial use, the customer retention is high. Intuit focuses on creating a clean and easy to user interface that simplifies the tax filing process. This helps with client retention but the big retention factor is Turbo Tax imports last year’s financial information into this year. It’s a hassle to re-enter all that information from your W-2s, W-9s, K-1s, investment accounts, etc. Turbo Tax makes it easy.
As people get older their tax filings usually get more complicated. A Turbo Tax user starts out with the $49.99 Basic offering. Then as they get married, have kids, save for retirement, buy a home, buy rental property, or start a business they’ll graduate to the $109.99 Turbo Tax Premier. The total number of tax filings per year will grow with the population, that’s around 1%. Turbo Tax’s revenue can grow faster than the growth in tax filings because customers move upward through Turbo Tax’s pricing levels.
Turbo Tax has about a 63 percent market share in the DIY segment and continues to increase that by 3 to 5 percent per year. The size of the DIY market also changes year to year. The better Turbo Tax software gets with complicated taxes, the more it opens up the DIY market. The last Tax Reform Bill removed the need for a lot of individual itemized deductions. This made tax filings simpler and it expanded the DIY market too.
No matter how good your software is some people want the comfort of knowing a live person can help them. Intuit offers Turbo Tax live. This program gives customers the opportunity to talk with a tax certified professional. For a modest price increase of course. If someone was on the fence about using Turbo Tax then Turbo Tax Live may give them the comfort to do so. Turbo Tax Live further expands the DIY segment and increases Turbo Tax’s potential revenue.
Intuit’s Turbo Tax business is an extremely profitable and consistent grower that generates a lot of excess cash for Intuit to reinvest back into its business or return it to shareholders.
Intuit’s internal hurdle rate for the reinvestment of capital is 15 percent. If management can’t find an appropriate investment that meets their required returns then management will return the excess capital back to shareholders. This is what we want to hear from management when it comes to capital management.
In 2018 Intuit generated a 68.2% return on invested capital. Over the last 10 years the lowest return on invested capital was 19% and most of the time it was between 25 to 30 percent.
Given Intuit’s high returns on invested capital, the company has all the capital they need for reinvestment. But they won’t find enough investments that meet their 15 percent hurdle rate. We expect Intuit to return the excess capital to shareholders with higher dividends and more share buybacks.
Now onto some of the risks to our investment in Intuit.
First is pre-filled taxes. Filling out your taxes is not fun. Why can’t the IRS just tell you what you owe and send you a bill? Some countries do this. And each year it seems the number of people demanding this in the U.S. increases. Usually this sentiment comes from the group who’s taxes are really simple.
If the U.S. went to pre-filled taxes this would kill Turbo Tax. We tend to think this is a low probability event. The costs involved with expanding the IRS and its infrastructure is a non-starter. The other roadblock comes down to a fundamental belief. Do you think the government should tell you what you owe and for you to prove the government wrong? Or do you think you should tell the government what you owe and for the government to prove you wrong?
We think the majority of people, especially here in the U.S., would fall into the second category.
The standard risk to QBO apply here.
We’re overestimating QBO potential market share.
We’re overestimating its growth in general.
We’re underestimating its current competitors.
We tried to keep our estimates of market share and near term growth subdued. It is very easy to get carried away since Intuit doesn’t face real competition in servicing small business. But we also didn’t want our valuation to rest on overzealous estimates.
Because QBO focuses on small business a recession would have a big impact.
Small business formation is pro-cyclical. When the economy is booming more new businesses are formed. When times are bad small business formation drops.
Compounding the problem is a recession causes existing small businesses to close.
Less formation and increased closures is not good for QBO subscriber growth.
Maybe the silver lining is a recession may force businesses to realize that their accounting systems are poor. This could lead them to a better system like QBO.
A recession would be a blip on the long-term trend of shifting from a spreadsheet based accounting systems to a more robust cloud based software as a service systems. But it is still a risk and it will hamper QBO in the short run.
SaaS companies are the investment du jour. Given their recent returns during this cycle it is easy to see why. A medium post titled History of Public SaaS Returns and Valuations, there’s link in the description, posts a chart of each SaaS company’s total return since its IPO. The average return since IPO is 5.3 times and the median is 4 times. And these returns on average happen within the first 3 to 4 years.
Given the great returns it is easy to see why SaaS companies are so dear right now but when an industry becomes an investment darling its valuations tend to become stretched.
Intuit is not in bubble valuation territory but it is definitely benefiting from the general price trend and favorable sentiment in SaaS companies. Even though Intuit is not a pure play SaaS company, when growth and valuation estimates come back down for the entire SaaS sector Intuit will be affected too.
Intuit’s industry leading position and long-term growth will remain intact. So we view any price pullback below our estimate of fair value as a great opportunity to add to our position.
To get to our estimate of fair value, we used a discounted cash flow model because of Intuit’s high current growth rates, margin profile, and target capital structure.
We used a 25% market share for QBO over the next 10 years. We expect Intuit’s Consumer Business to grow at 6%. We used 1% for its pro-connect and its legacy QuickBooks Desktop business. This builds a 10% annual growth rate over the next 10 years. It then converges towards a long-term growth rate of 3%.
Our base case fair value for Intuit is $268 per share. As I record this, Intuit is trading at $274 per share. So a slight premium to our estimate of fare value.
If or when Intuit trades below our fair value we will look to add to our position.
If you enjoyed this episode please leave us a rating in your favorite podcast player. If you want to get the AMM Dividend Letter as soon as it’s released, please use the link in the description. If you’re a financial advisor and you want to use the AMM Dividend Growth Strategy as a separately managed account or an individual investor that’s interested in our dividend growth strategy, please give me a call at 888-999-1395 or visit us at www.amminvest.com.
Until next time.
