Motley Fool Hidden Gems Investing - The IRS Enters the Tax Game

Episode Date: October 18, 2023

The IRS has good news for taxpayers and bad news for Intuit’s TurboTax.     (00:16) Jason Moser and Dylan Lewis discuss:   - The IRS’ Direct File pilot program coming to 13 states, and what it means for Intuit’s TurboTax. - Why activist investor Engaged Capital is interested in VF Corp – the owner of Vans, The North Face, and Supreme. - How Roblox’s return to office plans are a sign of the times for the pandemic darling.    (14:04) Ricky Mulvey caught up with Nick Sciple to check in on Next Era Energy and the rocky ride for utility stocks so far this year.   Companies discussed: INTU, VFC, RBLX, NEE, NEP, BWXT, CNQ, CEG   Host: Dylan Lewis Guests: Jason Moser, Ricky Mulvey, Nick Sciple Engineers: Tim Sparks   Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. Dylan Lewis. Activist investors are eyeing wardrobe staples, and the IRS might have some good news for taxpayers. Motley Fool Money starts now. I'm Dylan Lewis, and I'm joined over the airwaves by Motley Fool analyst Jason Moser. Jason, thanks for joining me! Jason Moser. Hey, Dylan! Happy to be here! Thanks for having me! We've got an activist investor eyeing sneakers and the maker of virtual worlds telling employees they need to come back in person. But our first story today, Jason, is focused on the tax man.

The IRS announced plans to launch its own free tax filing program in 13 states next year, and the agency expects hundreds of thousands of taxpayers to use direct file in the pilot program. Jason, this ends a very long period where it seemed like the IRS was very comfortable letting other companies handle tax filing, even free tax filing, for taxpayers. Yeah, well, understandably so. Building that infrastructure is obviously very complicated when you have a lot of companies out there that have already done it. Sometimes it's easier to saddle up and build partnerships as opposed to trying to go out on your own. This, though, seems like a response primarily, at least, to bad behavior on the part of Intuit,

I think for the most part. Intuit is the owner of TurboTax. We saw recently TurboTax settled litigation there in regard to deceptive advertising practices, and ultimately providing those quote-unquote free tax services for lower-income earners, folks who qualify for those free offerings, but then either upselling them or trying to get them into other products or services that they don't necessarily need. Ultimately, free not really meaning free. That's a problem. That's predatory. I don't think anybody really enjoys doing taxes. Maybe there are a few souls out there that do CPAs. I'm just kidding. Don't come after me. It's tough. It's not something that I think most people look forward to doing.

If you are in that lower income earner demo and you're being sold this false bill of goods where you're given this quote-unquote free service that turns out to not be free or they're trying to push you into other things that cost money. I understand, too, it's a business. They need to make money, but by the same token, there's this thing called doing right by your customers as well. Be a good actor. You have a lot of opportunity to build a great reputation in the space. TurboTax has had a few stumbles along the way. I certainly do not fault the IRS for getting in here and trying this. There is data that says it is something that would be received well. They did conduct surveys. They found 72% of taxpayers would be interested

in using a free electronic tax filing service offered by the IRS. So, when you have that data, I think then you owe it to yourself and you owe it to the citizens to dig a little further and see if there is a solution that you can bring to the table. I'm with you, Jason. I do feel like maybe this is a little bit of a development of TurboTax's own doing. It's also something that's a consequence of the Inflation Reduction Act. This is where we saw the funding for more IRS initiatives. This is one of those, but we also saw the agency scale up and really be able to handle

more taxpayer calls and reducing wait times on the phones. I think we're going to continue to see more innovation from the agency because of the funding in that legislation. One of the things I'm curious about is, I mentioned that this is a pilot and there are only 13 states and there are only certain taxpayers that will be eligible for it. How meaningful do we need to think about this as being, with respect to Intuit's tax prep business and the direction of it? Overall, TurboTax is important to Intuit. That should come as no surprise. I think Intuit is broken out into a few different segments.

They have the consumer division, which ultimately is mostly the TurboTax business, and that's about 30% of overall revenue for Intuit. It's a big part of the revenue picture. It's not the biggest, but it's a meaningful part of the business. Then furthermore, that consumer division, it's high-margin revenue. You're talking about around 65% operating margin within that segment. It's a meaningful driver of profits for the company, so it does matter. I think in the near-term, it's likely nonexistent as far as impact to it, because the burden of proof right now is on the IRS to actually show they can bring a solution to the table. Getting the survey feedback is one thing, saying that you want to do something is something

else, but then executing is really what it all boils down to. We don't know if ultimately they will be able to execute on this. I hope that they can, because I think ultimately this has the potential to be something that not only could be seen as a solution for certain taxpayers, but it's also something that could ultimately light a fire under Intuit and TurboTax to maybe do something a little bit differently, right? I mean, Intuit has a choice here in how they respond. I mean, they don't have to offer up quote-unquote deceptive advertising, right? I mean, they can change their behavior and be seen as a more reputable and trustworthy player in this space if they decide to do that. I do understand

the concern. I mean, there are concerns that maybe the ones that are doing the taxing shouldn't also be the ones providing the tax filing services, maybe a little bit of a conflict of interest there. I understand that, that's fair enough. But I don't think that's a blanket sentiment among all consumers, particularly the lower-income earners that this impacts. Maybe the mistake to make here is offering more choice in the matter, not less. Just because someone has the option to use a free service doesn't mean they have to. They can take a pass and use another service if they so choose. But it does feel like, in this case, maybe the mistake is to offer more choice and not less. Alright, switching gears and checking

in on retail, activist investor Engage Capital is taking a look at Vans and saying, hey, you've got some nice shoes over there. The company is interested in the company that owns Vans, as well as North Face and some other retail brands, Dickies and Supreme. That's VF Corp. It shares up 15% after we've realized that this activist investor has a larger stake in this business and is becoming vocal about the direction they'd like to see this company going in. Jason, the activist investor here is blaming previous management for poor strategic guidance and also pointing out that the company has lower margins than its peers. Taking a step back and looking at VF Corp here, this is

not exactly a company that's lit the world on fire. Do you feel like maybe the activist investor has some good points here? Probably so. The first thing that came to mind, and I think you've been here long enough, you must have gotten those vans, those Fool vans that we got for one of our... The slip-ons, yeah. Yeah, yeah. I still have those up in my closet upstairs. I figure, at some point or another, I'm going to get a bunch of old-school Fools to sign them and maybe auction them off for charity or something. That could be fun. But yeah, I think by any measure, look, VF has been a bad performer. You look at the five-year chart, the stock is down 75%.

It's down around 30% year-to-date. In situations like these, these are situations where most often it's addition by subtraction. It's more about cutting costs, maximizing efficiencies, and whittling down the business in order to boost performance. Then the age-old question that comes with things like this, is this a value play or is this a value trap? With the value play, I think the key is to really be able to identify the short-term catalyst that will turn things around. In this case, the short-term catalyst is likely the activist investor. We already saw a positive response from the market. Those types of pops are short-lived. But generally speaking, the catalyst is perhaps this activist can change things a little bit

get this business going back in the right direction. To be clear, it needs it. If you look at the performance of the business, if you look at the fundamentals of the business, it is a challenged business. Margins over time have gotten hammered. Gross margin is down 2.5% points since 2019, but net margin down 11.3% points. It's burning through some cash too. If you look at the balance sheet, cash went from $1.3 billion in 2020 to just over $800 million. now. They have $5.7 billion in long-term debt. Perhaps even more concerning, especially for income investors, is you look at the dividend yield for this business now, 9.8%. That looks amazing, right? But whenever you see a yield like that, your first reaction should be like, okay,

why? Because that is abnormally high. Can they afford this dividend? You look at the payout ratio for VF right now, which ultimately, that looks at the dividends paid compared to net income, that payout ratio is over 530%. You want that number down below 50%. It's not a good situation right now for VF. I think, again, you go back to that addition, buy subtraction, maybe activists can get in here and change things around and aid the fundamentals because it is a business with a lot of brands that do collectively make a lot of money, but they definitely got their work cut out. Our final story today. The virtual world is good for play, but maybe not for work. Video game and metaverse company Roblox is

updating its remote work policy. The business was fully remote, but beginning next year, it will be expecting employees to work in the office three days a week. Jason, this feels a lot like when Zoom announced that they wanted people back in the office a little while back. Yeah. I guess the irony here should be lost on no one. Roblox is a business where success is going to be based on creativity and innovation. Roblox is certainly one of those businesses where that's more the case than others. I think for that, collaboration is a key part of that. Collaboration is just really difficult in the remote work and the virtual meeting landscape. It's just not easy. In some cases, the costs outweigh the benefits. Maybe that's

what leadership realized in this case. You mentioned Zoom. I think it's a really important point to note. Roblox isn't the only one. You literally have the companies responsible for virtual work tools telling us that it ain't working and it's time to go back. I think it's worth at least acknowledging that and understanding what these businesses are doing and why. I think when you read the e-mail that was sent to the Roblox workforce, it really did boil down to that in-person, face-to-face collaboration, coming away with ideas and actual to-do items that just don't pop up organically the same way in a Zoom meeting. It's a difficult balance, and some companies are making decisions to go ahead and really take care of business

and get people back in the same room together. You were talking about this earlier Just from a culture standpoint, in the way that we were just discussing it, I do wonder a little bit if there is a cost and a headcount element here, where a lot of these businesses did a lot of hiring. I think in Roblox's case, their headcount tripled during the pandemic boom. It's a mix here. This is the culture we've decided we want to have. Also, it is a way for us to start to reduce our headcount and force people into tough

decisions, especially people who necessarily aren't near an office. I would imagine that leadership looks at this as an opportunity to right-size the business to a degree. They can make this decision, and they probably make this decision knowing full and well that some employees are just going to say, no way, I don't want to be any part of this, I'm quitting. The company is going to say, okay, that's fine, we understand. We have a severance package that we're offering for anyone who feels like this is not the right fit for them. It feels like they're coming at this from a diplomatic perspective and understanding that I get why folks love remote work so much. It is ultimate freedom

with virtually no oversight. A lot of times that'll be abused and ultimately it boils down to the company's performance. If the business isn't performing, they have to look at ways to change that. Again, when you look over the last three or four years, the one single biggest change that any and all businesses made here over the last three to four years was this move over to remote work, virtual work and whatnot. You have to at least look at that and say, okay, that's the biggest change we've made. Maybe we went too far in one direction. It's a difficult balancing act on the hybrid side. You have to come up with some firm guidelines. This is what you want. If you guys don't like it, that's cool. We respect that. We've got a severance package for

you. We're going to keep on moving forward." Again, reading through the email that was sent to employees, I think it was thoughtful. I think it acknowledged both sides of the argument there. I certainly respect management for making this decision, and it seems like they're going to stand by it. Jason, we're remote today, so I'm hoping that you're enjoying that ultimate freedom. Looking forward to getting back in the studio with you again and taping in person soon. Absolutely, me too. Thanks for being on today! You just found out that your sales team is at risk of missing quota. Don't panic. Just ask Rippling AI. Since it's built on your real-time people and business data, Rippling AI can pull metrics from Rippling and Salesforce into a meeting-ready dashboard showing quota attainment, headcount plan, and monthly revenue to quota by region.

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Coming up, utility stocks were supposed to be boring, but many have taken a hit this year. Ricky Mulvey caught up with Nick Seipel to check in on next era energy and some trends still going strong in the face of higher interest rates. Utility stocks aren't supposed to cause investors much of a headache, but they're having a rough year. The Vanguard Utilities Index Fund, ticker VPU, is down about 16% on the year. NextEra Energy, which owns America's largest electric utility, is trading near March 2020 lows. Nick Sciple, you follow the energy industry, so to set the table, what are investors looking for when they're buying a utility stock?

Thanks, Ricky. The short answer to that question really is safety. If you think about the type of businesses that utility companies are, they provide essential services like power and water, which no matter what the economic environment is, people tend to pay for. On top of that, utility companies are highly regulated, often enjoy a monopoly within their local jurisdiction. As a result, these are companies that produce steady income and can pay out steady dividends to shareholders over time. Very, very safe company. If you're a retiree who is expecting regular income, utilities tend to be the types of stocks for you. I'm still paying an electric bill, still using electricity as of this moment.

Why have investors generally soured on these utility stocks this year? I mentioned that the attractiveness of utilities is safety. That's also the attractive point of bonds. Over the past couple of years, we've seen interest rates surge up significantly, and that's made utility stocks less competitive with bonds than they were in the past. All bonds are even less risky than utilities. The risk-free rate is set by U.S. Treasuries, which are guaranteed by the U.S. government. As that risk-free rate ticks up higher, investors require a higher rate of return from riskier

assets like utilities and other stocks. And in the case of utilities, that often means that the stock price moves lower, so the dividend yields can move higher and start to reach equivalency with where bonds have moved. One that's fallen quite a bit that we mentioned is NextEra Energy. Throughout, at least for the past few years, this utility had traded at a much higher price tag than other utility stocks, such as Duke and Dominion. Before we get into necessarily the drop in price, which I guess we've already gotten into, Nick Sciple, why were expectations much higher? Why was this regulated monopoly so much different than other regulated monopolies?

Sure. The short answer to that really is faster growth. If you look at the long-term growth trajectory of NextEra Energy over the past several years, delivering growth in the 8% range versus other utilities, where you're looking at closer to 4% or 5%. There's really two arms of this business, both of which had some tailwinds behind it. First is the regulated utility side of the business. NextEra Energy owns Florida Power & Light, which is the big utility based in Florida. Obviously, Florida, very attractive market, has experienced meaningfully faster population growth than other jurisdictions, which has been a tailwind for the regulated utility in that market, which NextEra Energy owns. Also, they have an unregulated subsidiary

that sells competitive power into the market called NextEra Energy Resources. It's the world's largest generator of renewable energy from the wind and sun, and has been developing power projects for decades and selling that power to other utilities, energy consumers across the country. You've seen lots of growth as they've built lots of new renewable facilities over the past few years. However, that growth story appears to be slowing down, which is part of the reason you've seen the stock sell off so much. Yeah, NextEra Energy Partners, the green subsidiary, cut its dividend growth outlook in half, basically. This would seem to be the last thing that a utility company would

want to do. In this position, why is NextEra's management doing that? Sure. Just background, NextEra Energy Partners is a publicly traded limited partnership that NextEra Energy, the parent company, holds a 53% stake in. NextEra Energy Partners owns, acquires, and manages renewable energy projects, also some natural gas pipelines. Historically, NextEra Energy Partners has served a role as a financing vehicle for NextEra Energy, the parent company. NextEra Energy Partners has grown by acquiring projects developed by the parent company, NextEra Energy, which are then dropped down to the partnership, NextEra Energy Partners. That partnership will then acquire those projects from the

parent company, operate them, collect revenues via fixed-price power purchase agreements, and pay out the difference between its financing costs, what it costs to acquire those projects, and what it earns on the power production as dividends out to its shareholders. A big formula in being able to run that acquisition strategy by those assets that drop down from the parent company is cost of capital. Cost of capital has gone up for NextEra Energy Partners in a meaningful way. I mentioned earlier the increase in interest rates. NextEra Energy Partners typically uses debt or equity to acquire these projects. You've seen that the cost of debt move up significantly. The cost of capital has gone

up on the debt side, while the cash they're receiving from these fixed-price power purchase agreements remains the same. At the same time, that factor that I mentioned earlier of higher risk-free rates is really gravity to the price of dividend-focused investments. That's affected Nexair Energy Partners, driven down its stock price, which has increased its cost of equity as well. As a result, acquisitions that would have penciled out four or five years ago don't pencil out at today's cost of capital. If you're not going to be able to acquire new renewable power projects at the same rate as you were in the past, that trickles down to the solar dividend growth, which NextEra Energy Partners shared with investors in its outlook.

The company is now going to focus more on organic growth investments, reinvesting the cash that it earns within the business, rather than the acquisition-focused growth we've seen in the past. That slows down the dividend growth for NextEra Energy Partners. also likely means that the growth for NextEra Energy is going to slow down as well as one of its primary sources of funding from NextEra Energy partners starts to dry up. Taking a step back, one other thing that seems appealing about utility companies is that they trade at a lower beta. They're supposed to signal stability. Beta is a measure that basically tells investors a stock's up and downiness relative to the market.

But I know there's some controversy with using this measure. Do you think the decline in utilities says anything about Beta's usefulness as a metric. And then, when you're looking at stocks for the Fool, is this a stat that you really pay any attention to? Yeah. When it comes to the limitations on Beta's usefulness, this really illustrates one of those, in that Beta is a backwards-looking metric that doesn't really give you a complete picture of a company's risk profile. As you alluded to, Beta is really a measure of a stock's volatility relative to a given benchmark, usually the S&P 500. If you've got a Beta greater than one, that indicates the company is more volatile than the market. Beta less

than one indicates that a company is less volatile than the market. Just to put some numbers to that, if you take a company with a beta of 1.5% and the stock market moves up 1%, you would expect that company to move up 1.5% in response to the move. If you have a beta of 0.6% and the stock market moves up 1%, you'd expect that company to move only 0.6%. However, that correlation only really takes into account the past performance of a stock, not what it will do in the future. Moreover, it only reflects the relationship of the stock or the sector relative to the overall market, doesn't take into account the idiosyncratic risk that a company might have via its business decisions, like what we saw happen with NextEra Energy.

We had a prevailing interest rate environment that baked into that beta, less volatility into the company, and now we're in a new environment today. For me personally, I don't view volatility as real risk. Risk to me is losing your money over the long term, so that's not something that I tend to pay attention to. But at a glance, a beta can tell you something about the volatility of a company, and it can be used as shorthand. But I don't think it's particularly valuable for investing decisions. When you're looking at these energy companies, maybe you're not looking at the beta so much, but in this higher interest rate environment, you probably are looking at companies with strong balance sheets.

We can take this outside of utility stocks. Are there any that you're maybe paying a little bit more attention to in this tougher environment? One company that I've really been paying attention to the past couple of years in the traditional energy space is Canadian Natural Resources, ticker CNQ, has really benefited from surging oil prices over the past couple of years, has cut its debt in half and has subsequently accelerated capital return to shareholders under the current regime. The company is returning 50% of free cash flow, which includes accounts for dividends, to shareholders with the remaining 50% directed toward debt repayment. That cash flow policy is going to move to 100% returns to shareholders

when net debt reaches $10 billion, which is expected to occur sometime in the next 12 months. With oil price break-evens in the low 30s, oil trading near $90, this company is really producing significant cash and de-levering in this environment, returning cash to shareholders. So, in an environment where inflation is hurting lots of companies, the higher oil price is really helping Canadian natural resources, and investors are getting paid for it. I always like closing things out with you by asking about trends in energy. There's plenty to pay attention to right now, but do you think there are any trends in energy that maybe aren't getting enough attention by the financial media in the headlines?

Well, folks have maybe heard me talk about nuclear energy before, but I think nuclear energy still isn't getting enough attention from the general investing public. Really, the past two years, we've seen a real resurgence in interest, particularly political support worldwide. Both the U.S. and Canada have passed new tax credits that have been brought on to support nuclear energy and bring it into parity with other clean energy sources. The EU has labeled nuclear energy as green under its sustainable taxonomy. You've seen 11 European countries form an alliance earlier this year to promote nuclear power deployment. In Asia, you've seen multiple countries reverse plans to phase out nuclear reactors and now planning to construct

new reactors in companies like Japan and South Korea. There are certainly some investment opportunities out there in the market that I think are worth paying attention to. I'll give you a couple of them, both of which are trading at or near all-time highs. While the market may not be talking about it as much, it's certainly being reflected in the stock price. If you recall back when we did our stock march madness presentation back in March, we talked about BWX Technologies, which in addition to its status as a monopoly supplier of nuclear reactors for the U.S. Navy, also plays a key role in servicing, maintaining, and fueling the Canadian nuclear fleet and is positioned as a merchant supplier for next-generation

small modular reactors. To the extent you see next-generation small modular reactor build-outs accelerate at the end of this decade. BWXT is really going to be a significant beneficiary, and they're starting to generate revenue from that today. They also have some exciting opportunities in nuclear medicine that are expected to get approval later this year. Lots of tailwinds behind that business, particularly as more money is expected to be spent in deploying new nuclear. One other company that I would throw out there, also on the utilities theme, Constellation Energy Corporation, ticker CEG, worth paying attention to. It came public in early 2022 via a spinoff from Exelon. It was actually the No. 1 performer in the S&P 500 in 2022.

Exelon retained the regulated utility business that existed before it was spin-out, while Constellation took the competitive power generation and consumer-facing business. Its portfolio has over 30 gigawatts of capacity. Nearly 90% of its production is carbon-free, with nearly 86% of that coming from nuclear. It's the largest carbon-free energy producer in the United States, larger even than XTERRA, delivers about 10% of the total carbon-free electricity produced in the United States. To the extent we're going to see increasing nuclear energy consumption, Constellation Energy will be a beneficiary there. Just this week, announced plans to build the world's largest nuclear-powered clean hydrogen

production facility at its LaSalle, Illinois center, utilizing funding from the Department of Energy. It's also announced earlier this year a first-of-its-kind agreement with Microsoft to hourly match clean energy generation with the company's needs at one of its data centers. There's lots of room to expand those types of agreements with other companies that will pay a premium for clean energy. The company also has over $1.2 billion in unallocated capital available over the next couple of years to finance additional acquisitions of nuclear plants and other clean energy facilities. Since the spend, the company has expanded margins, has doubled its per share dividend, and has bought back $500 million in stock in the last two quarters. Management

continues to telegraph that the stock is cheap. Shares trade at over 20X forward earnings. You could argue it's a little aggressive for a utility, but with the prospects ahead of the business, certainly worth having on your radar. It could have that attractive growth that you saw from XTERRA Energy in the past. In this new environment, I think nuclear is more attractive than some of those renewable facilities. Nick Sciple, talking again about BWX Technologies. What you didn't mention is that it was the winner of the Stock March Madness competition back in March, but I guess that part is obvious. Anyway, as always, appreciate your time and your insight. Great to be here with you, Reagan.

As always, people on the program may own stocks mentioned, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Dylan Lewis. Thanks for listening! We'll be back tomorrow.