Why Intuit Investors Should Be Terrified

By Timothy Green Markets Fool.com

Intuit (NASDAQ: INTU), the company behind QuickBooks Online and TurboTax, makes a killing every time tax season rolls around. Nearly 34 million people used TurboTax last year to file their taxes, an increase of 12% compared to 2015. The company's consumer tax segment generated nearly $2 billion of revenue in fiscal 2016, accounting for 42% of the company's total.

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TurboTax is a wildly profitable business for Intuit, despite offering essentially the same service as countless other companies. Intuit has done a great job convincing tax filers to pay up for its services. The consumer tax segment generated $1.29 billion of operating income during fiscal 2016, good for an eye-popping segment operating margin of 65%.

Image source: Intuit.

There could be big trouble on the horizon for Intuit's biggest cash cow. Credit Karma, a start-up that made a name for itself by offering a free credit report service through its website and app, plans to launch a free tax filing service in January. Here's why Intuit investors should be terrified.

Giving it away for free

Intuit offers a free version of TurboTax Online, called Absolute Zero, that allows those with simple tax returns to file for free. Those who can use the simple 1040EZ or 1040A forms, instead of the full 1040 form, don't have to pay a dime to file their taxes.

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But TurboTax makes its money on people with more complicated taxes. If you itemize, have self-employment income, have capital gains or losses, or for any reason need the full 1040 form, TurboTax charges anywhere from $34.99 to $89.99 to file your federal taxes, with an additional charge for filing state taxes. This business model has been wildly successful for Intuit.

Credit Karma acquired AFJC Corporation, an online tax preparation company, earlier this year. This purchase will allow the company to roll out its Credit Karma Tax product in January, which offers completely free federal and state filing.

Unlike TurboTax, which relies on charging customers with complicated tax situations, Credit Karma Tax will have no fees whatsoever. There are a few items, like estate and trust income, that won't be supported at launch, but the full 1040 form and nearly every other tax form is supported. Credit Karma's business model is to use customers' information to recommend financial products, collecting a fee when a customer is approved for a credit card or loan.

Credit Karma's pitch for its tax service. Image source: Credit Karma.

Credit Karma currently has around 60 million users of its free credit report service, and there's no doubt that those users will be hearing about Credit Karma Tax once tax season rolls around. This product has the potential to completely upend the tax filing industry.

Intuit should be very worried

Intuit's TurboTax product certainly has some stickiness. Customers who have used the product in the past can import prior year results, saving time and frustration. And those who use other Intuit products in addition to TurboTax, like QuickBooks, may be less likely to switch.

But make no mistake: If Credit Karma's tax service works well, Intuit's very profitable business model is in serious trouble. If the process of e-filing taxes becomes commoditized, the likely result if Credit Karma Tax is successful, those lush 65% operating margins will become a thing of the past.

The market is completely ignoring this threat to Intuit's business model. The stock trades for more than 30 times earnings, a valuation that implies substantial growth going forward. With the consumer tax segment accounting for the bulk of the company's profit, there's a real chance Intuit's earnings will be hit hard if Credit Karma Tax is a success.

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Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Intuit. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.