News that the government has accused one of Jackson's major regional franchisees of preparing false tax returns will cause the tax preparer's name to suffer, even if the company itself is innocent. By Jeffrey R. Kosnett, Senior Editor April 4, 2007 Readers of this column frequently see us lampoon the market's penchant for hammering a stock at the first whiff of negative news, since often the problem is nothing more than a small embarrassment. But when the situation is serious and speaks to a company's very reputation, a stock isn't likely to bounce back quickly. So this week's down-and-up action in Jackson Hewitt (symbol JTX) is crazy. Jackson Hewitt is a tax-preparing franchiser that, for all intents and purposes, doubles as a small-loan company. It went public at $17 in 2004 as a spinoff from Cendant. Jackson shares rose substantially for a while, then they flattened in the $30 area, where the stock traded for most of 2006 and, until a few days ago, 2007. Then, on April 3, the stock collapsed $6, or nearly 18%, to $26.53 before recovering $2.51, or 9%, on April 4 to close at $29.04. The trading volume on both days was way above what's typical. This rebound sounds like one of those cases in which a good company's stock gets taken out and shot for no reason. That's what Morgan Stanley concluded as it upgraded the shares (to neutral) the day after the big drop. They trade now at only 14 times the average analyst earnings forecast for 2007. At that price, the stock looks cheap. But the story isn't so cut and dried. Jackson Hewitt has an image problem now. Since honest tax returns are more important to most people than, say, a brand of cereal, this makes it a stock to be extra cautious about. The Justice Department and the Internal Revenue Service are suing five corporations that own Jackson Hewitt franchises and their employees, charging massive fraud. The government says that employees at these offices, in Atlanta, Chicago, Detroit and Raleigh, filed frivolous or fictional returns that shorted the Treasury by $70 million and that some taxpayers paid kickbacks to employees at the tax preparer. This isn't about technicalities. It's Jay Leno monologue material. One of the most ridiculous cases is that of a barber who claimed a business deduction for 25,000 gallons of gasoline. Even a full-time trucker who violates the rules about hours on the road doesn't burn that much fuel. Jackson's corporate headquarters issued a statement saying don't blame our "network," blame a few of our franchisees. That's fair. The purported offenders write about 2% of Jackson Hewitt's business. They accounted for 105,000 of the 3.7 million returns that Jackson Hewitt offices handled in 2006. Notably, Jackson didn't say, as companies often do when they or their people get sued, that the claims are "without merit" or "baseless." Jackson added that it doesn't know if the event will or will not have a "material" effect on its earnings and cash flow. It is unclear what will happen to the parent company if some of the taxpayers who filed the false returns and get in trouble with the IRS blame Jackson Hewitt as well as its franchisees. Tax preparers who file falsified returns can go to prison. The IRS can demand back taxes and penalties from the taxpayers. If the taxpayer knew of the scheme, he or she is also liable for criminal charges. Returning to the investment implications, assume that tens of thousands of taxpayers decide now to avoid Jackson Hewitt offices. The typical customer doesn't distinguish between a company and franchisees, but knows the brand name. This year's tax-filing season is nearly over, so there's no reason to think Jackson Hewitt will fall far short of its 2007 guidance, which is that the number of returns it processes will rise 1% to 3% and that the average charge for each return will be 6% higher than it was a year ago (when it was $205). But -- and this is important -- Jackson Hewitt's financial strategy, cash flow and shareholder appeal depend on selling more franchises to expand its footprint around the country and to boost the caseload at each office. Any lingering damage to the brand's reputation will undermine these marketing efforts. The company's financial statements and its handouts to analysts already presented a mixed picture. Jackson Hewitt thinks of itself as a fast-growing company, but the most recent balance sheet, dated January 31, lists shareholder equity of $277 million, or $110 million below a year earlier. Earnings per share are growing only slightly faster than revenues, so unless the company stops advertising or it raises prices, or there's a burst of efficiency improvements, you can't count on expanding profit margins. More than half of the company's assets are classified as goodwill. There are no unrealized real estate gains or paper investment profits to unlock. This heightens the danger that if Jackson's reputation suffers lasting damage, it will have to write down the goodwill, further slicing shareholder equity. Furthermore, the issue of subprime credit could also intrude. Jackson Hewitt talks a lot in its financial statements and promotional literature about how it is a financial-services provider. It wants to be the tax preparer of choice "for the workforce of America," which it describes as people of moderate means who need their refunds right away, if not sooner. So Jackson earns a good deal of its profits from loans against pending tax refunds and on even earlier loans it issues in anticipation of future loans on the anticipated refunds. This generates major fees, but without big growth here, there's little chance that earnings will rise steadily. One of the banks that participated in this refund-loan program was HSBC, which lost heavily on subprime mortgages. HSBC has pulled out of tax-refund lending, which led Thomas Weisel Partners to downgrade Jackson Hewitt and cut earnings estimates back in March. That was before Jackson Hewitt's name got tarnished in the glare of negative publicity. Jackson has much work to do to right its stock.