In my personal opinion, the active development of AI can have a significant impact on a huge number of companies, one of which is H&R Block (NYSE:HRB). Despite the fact that the company’s shares are currently under pressure, I believe that we now have an attractive entry point for opening long positions. In my article, I would like to focus on how the development of AI can help increase business profitability by reducing operating costs in the coming years.
In my personal opinion, the introduction of AI can not only significantly increase the productivity of company employees, but also lead to a faster change in consumer behavior. First, I believe that the ability to automate routine tasks through the introduction of AI will allow the company to significantly reduce the number of seasonal associates, which can help increase the operating profitability of the business. Secondly, I think that increasing the convenience and efficiency of online interaction with companies through automatic data collection and time savings will help users to more quickly abandon the company’s offices, which will help reduce rental costs.
H&R Block prepares tax returns for its clients. The company operates in both online and offline segments. The company was founded in 1955 and operates in the US, Canada and Australia markets.
How AI implementation can increase profitability
If we look at the structure of a company’s operating expenses, we can see that salaries and bonuses are the largest part of operating expenses. So, according to the results of 2021 (fiscal) and 2022 (fiscal), labor costs (% of revenue) amounted to 36.3% and 37.6%, respectively. You can see the details in the chart below.
If we look at personnel costs in more detail, we will see that the largest share of expenses falls on field wages (23.4% of revenue), while expenses on other wages and benefits (% of revenue) are 8.2% and 6.0 %, respectively. At the heart of field wages is the need to hire seasonal associates to help manage the increased volume of work as the company’s business is seasonal. At the end of 2022 (fiscal), the company hired 69,900 seasonal associates, while the number of regular full time associates was 3,800. You can see the details in the chart below.
However, the answer to the question of whether AI can replace tax personnel is still ambiguous, so I would like to give an example of a survey on this topic from one of the AI professionals on his LinkedIn page, where we can see that most people agree that AI is technically capable of replacing humans in the coming years.
I believe that the introduction and active use of AI can significantly increase productivity, thus, the company can reduce the number of seasonal associates that need to be hired during the business season, which can lead to a significant reduction in operating costs and increase business profitability.
Next, I’d like to make my own assumptions about how much seasonal work cuts we might see in the future and what impact this will have on the company’s financials and stock valuation in the coming years. Predicting the impact of the technological revolution on a real business is not an easy task, so I will rely on the experience of existing companies, as well as on expert forecasts and my own judgments.
Firstly, I don’t think we will see a reduction in personnel costs in the next 2 years because the technology is still evolving and it will take a certain amount of time to implement it. Therefore, I conservatively assume that the company will be able to start reducing the number of seasonal staff by 5% between 2025 and 2027. Thus, expenses for seasonal staff (% of revenue) may decrease from 23.4% in 2022 to 20% by 2027. It is worth noting that predicting headcount reduction is a highly uncertain task, so I have tried to refrain from extremely ambitious goals, but have tried to reflect the inevitable increase in efficiency, which, in my personal opinion, looks rational. Based on the EY study and the Deloitte study, I concluded that AI can increase the efficiency of the workforce. Thus, you can see the details of my calculations below.
In addition, the introduction of AI can help reduce the cost of general customer support personnel, as voice recognition technologies and advanced AI-based chatbots can perform the task as professionally as humans, however, making fewer mistakes. which can increase customer loyalty.
In addition, in my forecasts, I predict a gradual reduction in rental costs starting in 2025. According to management’s comments during the Earnings Call, the largest segment of new customers is Gen Z, who prefer to use online products rather than visit offices and consultants. Based on my own calculations of the number of customers, I believe that between 2025 we can see a decrease in rental costs (% of revenue) by 0.2% annually in terms of revenue growth. So, I believe that we will see a reduction in rental costs from 11.9% in 2022 to 11.3% in 2027.
Thus, I assume that we can see a gradual increase in the operating margin of the business to 25.5% by 2027.
You can see the details of my Income statement forecast on the chart below. In my calculations, I assume that the company’s revenue will grow at 3% each year, which is in the lower range according to the company’s forecasts in the 2022 annual report (fiscal). I predict operating expenses such as other wages, benefits, marketing, D&A and other at a stable level (% of revenue) based on historical data. The greatest contribution to the growth of operating margin is made by the decrease in field wages and occupancy, the calculation details of which were described in the previous section.
I believe that my forecast is conservative and realistic, because a number of companies that already use AI for tax advice are able to demonstrate even higher levels of operating profitability. As an analogue company that is already actively using AI to automate the tax process, I chose Intuit (INTU), which owns the Turbo Tax service, which actively uses an online approach and AI algorithms to manage the process and solve routine tasks in the tax field, then how H&R Block uses both online and offline sales channels. According to Intuit’s annual report, Turbo Tax’s operating margin is just over 60%. I believe I can look at this as the level that H&R Block can achieve in the coming years through the transition to online customer interaction and the use of AI tools.
On the one hand, I am all set to value the company according to the DCF model, but I was convinced that the model is too sensitive to the input data, so I decided to use a multiplier-based valuation. In my model, I use my personal EBITDA forecast and an EV/EBITDA multiple of 7x, which I think is fair because: 1) the multiple is in line with historical data 2) the multiple is around 30% less than sector median, which looks safe and fair, given the low business growth rates. So, according to my estimate, the fair price of the share is $50.6 with an upside potential of 50%.
Margin: effective implementation of AI tools can boost employee productivity, which can support business operating profitability by reducing staff costs.
Revenue: implementing AI and increasing the efficiency of online interaction with the company can improve the loyalty of new and existing customers, as well as increase the competitiveness of the company, which can have a positive impact on both market share and revenue growth.
Margin: on the one hand, the use of AI can help the company reduce the number of seasonal associates, however, on the other hand, the active implementation of AI may require hiring additional staff to work with AI models and algorithms, which can lead to additional labor costs.
Regulation: the regulation of AI by the state through the introduction of additional taxes/fees can neutralize the economic effect of the introduction of new solutions.
Thus, I believe that buying company shares is an excellent bet on the development of AI in the long term. Firstly, the company’s business model and operating cost structure make it possible not only to use AI, but also to achieve improved financial performance by automating routine tasks and increasing user loyalty. I think this thesis is supported by the recent announcement of a partnership with Microsoft (MSFT), which aims to bring AI tools to the company using Azure OpenAI. Second, in line with fundamental valuation based on conservative assumptions, the target price for the share is $50.6 with an upside potential of 50%.
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