Posted by on January 29, 2017 11:48 pm
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While we remain in the purely abstract, theoretical and hypothetical realm of Trump tax reform – there have been no concrete proposals floated yet, with Trump as recently as a week ago slamming the critical border-adjustment tax, only to full reverse himself on it just a few days later – Bank of America has created a useful matrix taking a deep dive into the potential (and we do underline the word potential, because at this rate Trump may spend much of his first year dealing with immigration reform and Obamacare) implications of Trump’s tax reform.

As Bank of America’s Savita Subramanian writes in a note titled “Death and Tax Reform”, the BofA strategist predicts that tax reform in its entirety could add as much as $5-6 to near-term S&P 500 EPS “as benefits are front-loaded.” Whether or not tax reform would be accretive to EPS is highly dependent on the implementation details, which it then analyzes. 

Starting at the top, according to Savita 2017 could be a watershed year from a tax reform perspective. Trump has continuously stated that tax reform is a priority, and there is evidence of widespread support in Congress. Tax reform could be enacted through reconciliation without the risk of being filibustered, suggesting the timing could be imminent. Corporate tax reform could have a significant impact on S&P 500 earnings, corporate behavior and capital markets. Much has been written on the timing, funding and process by which corporate tax reform could be enacted. In this report, we use House Speaker Paul Ryan’s Blueprint proposal as a starting point in quantifying the impact of corporate tax reform on the S&P 500, with some scenario analysis to account for differences included in the final bill (such as Trump’s proposals). The bank’s analysis is focused specifically on the impact of corporate tax reform, however we recognize that there are many other factors that can impact the sensitivity analysis (e.g. changes to household income tax rates, infrastructure spending, etc.).

BofA estimates that the Blueprint proposal would initially boost S&P 500 EPS by $5-6, assuming the end of interest expense deductions only applies to new debt, or is phased in over time. But the devil is in the details. Over time, the loss of the interest tax shield would be a significant drag on earnings as existing debt is refinanced. Additionally, the corporate tax rate is critical in determining whether or not the tax reform policies end up being accretive to earnings on a sustained basis. Savita estimates that at the 20% tax rate, the Blueprint would be modestly accretive, the benefit would triple under Trump’s proposed 15% tax rate, but at a higher 25% tax rate that would appease the deficit hawks in Congress, the benefit would turn to a negative over time (Table 2). The bank also estimates a one-time $8-9 charge to GAAP EPS that would be associated with the discounted repatriation tax.

The bank then focuss on topics that have large implications for US equity investor, but it is important to consider corporate tax reform holistically rather than drawing major implications from each measure in isolation:

  • Reducing the US corporate tax rate
  • Repatriation – mandatory tax on overseas profits
  • Border adjustment tax
  • Removal of interest expense deduction

These tax considerations summarized:

Cutting corporate tax rate could add $8-9 to EPS

Our starting point is the US statutory corporate tax rate. If it were lowered from 35% to 20% and the US moved to a territorial tax system (no longer taxing foreign profits), it would boost S&P 500 EPS by an estimated 12% ($17 to 2018 EPS). We assume companies would be able to retain half of the benefit ($8-9) and the remainder would be passed on to customers or competed away. For instance, a lasting impact to Utilities’ profits is unlikely, as the benefit would be passed on via regulated pricing. 

Repatriation: Buybacks could boost EPS by 3%

Both Trump and the Blueprint support a mandatory (as opposed to 2004’s optional) tax of overseas earnings of US firms’ subsidiaries at reduced rates. Non-Financials in the S&P hold at least $1.2tn (mostly Tech and Health Care). If half was used for buybacks, this could add 3% ($4) to S&P 500 EPS. A redux of 2004 where companies used 80% of cash for buybacks may be less likely, in our view. For if repatriation is accompanied by an end to interest expense deductions, companies may choose to pay down debt over buybacks.

Border adjustment tax (BAT) hits EPS by $5-6

While Trump has described the BAT as being “too complicated,” White House press secretary Spicer’s recent comments call into question his stance. This is a key component of the Blueprint and would generate significant revenue. First-order impacts could be significant, with border adjustments detracting $5-6 from 2018 EPS — nearly 80% of the drag comes from the consumer sectors. The second order impacts — product pricing, pricing within the supply chain, exchange rates, foreign policy reactions, etc.-— while harder to quantify, are important to consider.

End to interest deductibility could detract 4% from EPS

We estimate that over time, the removal of the interest expense deduction would detract about 4% from S&P 500 EPS. The ending of interest deductibility could also increase the cost of debt by an incremental 25%, which could have longer term ramifications for capital structures and funding.

The government revenue associated with each of these is included in the table below.

From a sector and industry perspective there are haves and have-nots based on each policy, but in aggregate most sectors have some puts and some takes based on tax reform. The table below shows some relevant aggregate statistics by sector that are used in the subsequent analysis.

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Next, BofA breaks down the impact of the four components of tax reform starting with…

Cutting the corporate tax rate

The best starting point for analyzing corporate tax reform is the US statutory corporate tax rate, as this rate is critical in determining the impact of other proposed changes (border adjustments, interest deductibility, etc.). If the tax rate were lowered from 35% to 20% and the US moved to a territorial tax system (no longer taxing foreign profits), all else equal, we estimate an initial boost to S&P 500 EPS of 12% ($17 to 2018 EPS). However, over time, some of this benefit could be passed on to customers via lower prices — for instance, it is unlikely that there will be any major long-lasting impact from tax reform for Utilities sector profits, as any benefit/cost would likely be passed through to customers when incorporated into each company’s regulated pricing. The benefit would also be offset by some of the other changes discussed in subsequent sections. We assume that S&P 500 companies would be able to retain half of the benefit, or roughly $8 of 2018E EPS. Below, we show the estimated EPS impacts on each  sector based on a tax rate of 20%.

While the effective tax rate of the S&P 500 is generally about 28% (currently closer to 25% due to the recent commodity recession), we estimate that the tax rate for the S&P 500’s domestic operations is much higher at roughly 33% — although this includes state and local taxes. If all companies with tax rates above the proposed new tax rate of 20% were to drop to 20%, and no companies provisioned for US taxes  on foreign profits, we estimate the domestic effective tax rate for the S&P 500 would fall in line with its foreign tax rate of roughly 19%. This would represent a 9ppt decrease in the current S&P 500 tax rate and a 12% increase in EPS. We show the sensitivity to S&P 500 EPS to different assumed tax rates in the chart below, but we reiterate that these estimates exaggerate the actual impact on profits, as a significant portion of these benefits would likely be passed on to consumers via lower prices. We assume that in aggregate, roughly half of the gains from the lower tax rate would be retained (i.e. half of the amounts shown in the sensitivity analysis in Chart 2).

The market is beginning to price in the benefits of tax cuts , but we may still be in the early days – note that potential beneficiaries of fiscal stimulus (i.e. infrastructure spending) have seen an 18% multiple re-rating but de minimis fundamental support, whereas potential beneficiaries of lower corporate tax rates have seen performance driven nearly equivalently by multiples and earnings.

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Repatriation likely under both Blueprint and Trump plans

Mandatory tax on overseas profits of 8.75% under Blueprint, 10% under Trump. The US currently operates under a tax system in which the domestic earnings of US corporates are taxed at the federal US corporate rate (35%) and any overseas earnings that are repatriated are taxed at this rate less a credit for foreign taxes paid on those same earnings. Many multinationals’ foreign earnings thus remain parked offshore, allowing corporations to avoid the tax hit associated with bringing them back to the US. Both Trump and the House (under Ryan) have proposed a mandatory tax of overseas earnings of US firms’ foreign subsidiaries at reduced rates, such that this cash can be brought back and put to work in the US. This differs from the 2004 repatriation tax holiday, which was optional.

Under the Blueprint, accumulated overseas earnings will be subject to a transition tax of 8.75% (for those held in cash/cash equivalents) or 3.5% (for all other holdings), with companies able to pay the tax liability over an eight-year period. This would be part of broader tax reform, where a proposed territorial tax system would exempt companies’ foreign income from US taxes and prevent future buildup of overseas profits as companies would be free to bring them home. Trump’s plan calls for a one-time deemed repatriation of overseas corporate profits at a 10% tax rate.

The Tax Policy Center estimates that a repatriation tax holiday would generate approximately $150bn in tax receipts under Trump’s plan (over 10 years) and $140bn under the Blueprint (over 8 years). The Tax Foundation similarly estimates that a repatriation act could drive spending amounting to $185-200bn in revenues through 2025, which could help fund infrastructure/defense spending.

S&P 500 companies could bring back over $1tn – mostly in Tech & Health Care. Our FX team has written that US corporates in aggregate (including Financials) hold ~$2tn in cash overseas, and their work suggests that nearly half is concentrated within 20 companies. Similarly, as we discuss below, half of the repatriated cash following the 2004 Homeland Investment Act came from just 15 companies, predominantly in Pharma and Tech. Our own analysis of the S&P 500 (based on filings and estimates from our analysts) suggests that non-Financials in the S&P hold approximately $1.2tn overseas, nearly three-quarters of which is in Tech and Health Care (Chart 4).

Post-repatriation cash use: will this time be different?

Valuations, investor preference, growth & leverage ratios suggest less buybacks While any potential restrictions on the use of repatriated earnings are still unknown, we suspect that a pick-up in buybacks is likely, but that a lower proportion will be used for buybacks today than during the last repatriation holiday. Valuations were generally more attractive in 2004-2005 on most metrics (Table 9), and we’ve found that buybacks tend to be more rewarded when stocks are cheap (Chart 8). Additionally, the largest buybacks have not generated alpha for the last several years, as investors have increasingly agitated for companies to use their excess cash on pro-growth investments (namely capex.) According to BofAML’s latest Global Fund Manager Survey, 60% of investors want companies to increase capex spending, vs. 17% who want companies to return cash to shareholders (Exhibit 1). This compares to a majority of investors desiring companies to return cash to shareholders when the HIA was passed in late 2004.

Companies may also feel less pressure to bolster per share metrics by reducing share count if top line is recovering and organic growth is finally materializing. And from a capital structure perspective, if leverage loses its tax benefit, given that leverage ratios are already high (see below) companies may be less likely to reduce their equity capital base, as that would marginally increase their weighted average cost of capital.

Special dividends, pay-down of debt may be other likely uses

Companies may also return the cash to shareholders by issuing a one-time special dividend: income remains in-demand, given that both interest rates and dividend payout ratios remain historically low. And if a repatriation tax holiday comes within the context of broader tax reform that includes an end to the deductibility of interest expense, companies may choose to pay down debt over other uses of cash, in an attempt to skew their balance sheets less toward debt and more toward equity. Deleveraging balance sheets may also be spurred by a demonstrable move in interest rates over the last twelve months. Leverage for S&P non-Financials has steadily been ticking up over the last few years, and, if we exclude the cash-rich Technology sector, leverage is approaching all-time highs (Chart 9).

Potential EPS impacts

$8-9 (6-7%) hit to GAAP EPS from the mandatory tax

We estimate that the tax of accumulated overseas profits of $1.2tn should result in a cash tax impact of $100-120bn (which may be allowed to be paid over 8-10 years), and a one-time hit to GAAP EPS of $8-9 (a lower $65-80bn, given that a several large multinationals such as AAPL already provision a portion of their overseas profits for US taxes and have effective US tax rates well above the US statutory rate). Our analysis assumes Trump’s/the Blueprint’s proposed rates of 8.75%/10%, and that all overseas profits are hit with this one-time tax, as suggested by their plans. See Table 10.

Note that our estimate of ~$1.2tn of cumulative profits overseas is based on estimates from us, our fundamental analysts, and company filings, where in many cases only overseas cash but not other indefinitely invested earnings are disclosed/estimated. Thus, the tax on these earnings could be slightly higher, though the Blueprint would tax earnings not held in cash at a lower 3.5% rate. (We conservatively assume our estimated $1.2tn is all cash and use the higher 8.75% rate under the Blueprint and 10% under Trump’s plan in our below analysis).

We estimate share buybacks add $4 (or as high as $6) to EPS (GAAP & non-GAAP)

If the full $1.2tn that we estimate is overseas for the S&P 500 ex. Financials & Real Estate is brought back (given the tax is mandatory and will be paid either way) and 50% is used on buybacks (~3% of S&P 500 market cap), this could add ~$4 to S&P 500 EPS. And if 80% (~4% of market cap) were used on buybacks, similar to NBER’s estimate of what occurred following the 2004 tax holiday, this could add $6 to EPS. (The difference between the Trump and Blueprint tax rates is small, leading to only cents in index EPS). If one assumed companies only brought half of their offshore cash home immediately, even though the full amount was taxed, these benefits would be cut in half.

Note that buyback programs may span several years, which could spread out some of the EPS benefit below. But if one assumes a buyback is fully executed in Year 1, this provides a one-time boost to EPS growth and a recurring benefit to future EPS given a permanently lower share count.

Cross-asset implications of repatriation

Repatriation should spur USD-buying – up to 40% may be non-USD denominated.  While few companies disclose the currency composition of their offshore cash, our FX team estimates that 60-75% is already in USD while 25-40% is non-dollar-denominated. (If we extrapolate based on the S&P 500’s geographic revenue exposure, the largest proportion could be in Europe, followed by emerging Asia). This may create USD strength via buying pressure (which they estimate could amount to $250-$400bn if half of all offshore cash, which they estimate at ~$2tn, was repatriated). Their analysis of the EUR-USD during the last repatriation holiday suggests an “announcement effect” is likely, as the dollar strengthened ahead of the bulk of the actual repatriation flows.

Repatriation could put upward pressure on bank funding costs. Our rates team’s analysis of some of the largest multinationals with offshore cash suggests ~70% of cash is invested in securities with maturities greater than one year, likely given the assumption that these funds would be indefinitely reinvested, and the remaining 30% has longer maturities. See table below. They believe repatriation could  put upward pressure on bank funding costs as firms reduce their holdings in these short-term investments. According to Crane Data on offshore money fund holdings, our rates team cites that $161bn of offshore funds are held in commercial paper and CDs, of which the majority are from financial institutions with Japan, France and Canada the largest issuers.

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Border adjustment tax analysis

A new tax policy outlined in the Blueprint proposal that has been getting a lot of attention recently is the border adjustment tax, or the application of border adjustments to a company’s imports and exports. While Trump has described the proposal as being “too complicated,” it is a key component of the Blueprint plan and should not be ignored. Additionally, White House press secretary Sean Spicer’s recent reference to “…the plan taking shape right now, using comprehensive tax reform as a means to tax imports from countries…” could be a sign that Trump is not as against the proposal his other comments would indicate.

This policy would effectively result in the tax authorities recognizing all sales that take place in the US (regardless of where they are produced) and all the domestic costs incurred to produce goods and services for customers (regardless of where the sale takes place). As a result, net importers (such as many retailers) would suffer, as they would have to pay taxes on their domestic sales without being able to deduct a significant portion of their costs of production. Conversely, net exporters (companies with much of their production in the US but sales outside of the US) would stand to benefit from not having to pay taxes on their foreign sales while being able to deduct a significant proportion of production costs (Exhibit 3). Purely domestic companies would be unaffected.

Even if border adjustments are enacted, there is significant uncertainty around implementation details. For this analysis, we focus on the first-order impact of border adjustments, but we recognize there would be significant second order impacts on the pricing of products, pricing within the supply chain, foreign exchange rates as well as foreign policy reactions. (We discuss many of these second order impacts later in this report.) For the current exercise, we also ignored the cost of services as the implementation of these rules would be more complicated. See the Methodology section for more details.

We estimate that at a 20% tax rate, border adjustments would detract $5-6 from 2018 EPS, with nearly 80% of the drag coming from the Consumer Discretionary and Consumer Staples sectors (roughly evenly split). This impact includes a 50% haircut to account for offsets from alternate sourcing, currency rates and pricing power. On one hand, we may be drastically underestimating the impact because we have not included the second-order impacts on the supply chain. For example, many retailers source the bulk of their goods from domestic suppliers, who source their goods from overseas suppliers. So while the original retailer may not feel the direct tax hit from importing goods, the supplier that took the tax hit would likely pass along a significant portion of this via a higher cost. On the other hand, the supplier  or the retailer could look for alternate domestic sources for those products, but it would largely depend on whether the cost differential of production between the US and overseas exceeded the border adjustment tax. Some key components in determining the cost differential are the foreign exchange rates (more on this below) and labor costs. In the end, the net impact of the border adjustment taxes will be driven by a complex interplay between corporate tax rates, pricing power, foreign exchange moves, foreign versus domestic availability and cost differentials.

Offsetting BAT with a little math and some price increases

A company could fully offset the border adjustment tax by raising prices such that the after-tax increase in sales would exceed the drag from the lost deduction of costs. All else equal, the break-even price increase would be equivalent to the cost of goods sold as a % of sales multiplied by net % imported and the tax to after-tax ratio, which at a 20% rate is 0.25 (20%/80%). As an example, a company with a 25% gross margin that imports 30% of its goods would need to increase its prices by of 5-6% to offset the border adjustment tax.

Offsetting BAT with FX

Some of the increase in the after-tax cost of imported goods can also be offset by a strengthening dollar. For example, companies producing goods in Mexico, which stand to see a 25% increase in the cost of imported goods, should see the cost increase partially offset by the 13% devaluation of the Mexican Peso against the US dollar since the election. The net cost increase is a more digestible 9%, especially when you also consider that the Peso has devalued nearly 30% since its 2013 peak. While it may offer little consolation to corporates, the US Dollar Index is up over 25% since mid-2014, so the border adjustment tax would presumably act as a reversal of the lowered cost of overseas production over that period.

Border adjustment sensitivity analysis

The table below illustrates how the change in the tax rate and the application of the border adjustment tax would impact the domestic earnings of a hypothetical company with sensitivity to different tax rates and net export assumptions. We assumed the company has a 40% gross margin, operating expenses are 20% of sales and an initial tax rate of 35%. As you would expect, the biggest benefit would accrue to  companies with significant net exports at a high domestic tax rate (bigger tax shield) and the most negative impact to significant net imports at a high domestic tax rate (higher taxes on higher taxable income).

Below we highlight industries which could potentially benefit most / be hurt most by the BAT.

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No interest tax shield

Another key offset to the lower corporate tax rate is the proposed ending of the deduction of net interest expense. We assume that this rule would apply to new debt and that existing debt would be grandfathered. This tax shield removal would increase the cost of debt by an incremental 25% (not to mention the 100bp+ rise in long-term interest rates seen since the summer of 2016). In the table below, we illustrate the impact on S&P 500 corporate profits. We estimate that over time, the removal of the interest rate deduction would detract about 4%, or $4-5 from S&P 500 2018 EPS.

Many investors assume that interest deductions would likely apply only to new debt, and if this were the case, the drag would be gradual for the overall S&P 500 as debt matures and is refinanced. Companies have shifted the composition of their debt toward longer maturities and fixed rates. We estimate an average S&P 500 debt maturity of over eight years, with just one-third maturing within the next three years. The grandfathering of existing debt is a reasonable assumption, but not a sure thing, in our view. There is a possibility that legislators apply it to all debt on the grounds that most companies are expected to be net beneficiaries of comprehensive tax reform.

There is also a possibility that this policy is phased in over a number of years, with certain portions of the existing debt losing their interest deductibility over time.

The most negatively impacted companies would clearly be the ones with the most leverage, in addition to those with depressed earnings (Metals & Mining, Energy, etc.). We have again excluded Utilities from this analysis, because although the sector has a lot of leverage, for these companies, there would likely be a pass through to customers in determining their allowed rate increase.

How will levered companies react?

Companies will likely grow comfortable with a smaller amount of debt, retain more earnings, use less cash for dividends and share buybacks, and potentially draw down cash if they have it. If a tax holiday is also granted, that might offset the loss of benefit. Companies that regularly issue long-term debt may choose to reduce that burden to offset the tax change, and find those funds elsewhere. We find it unlikely that the change would result in a surge in equity issuance, unless the change applies to existing debt, which is unlikely in our view. While this change should be taken as a line item in a wholistic bill, there are victims and beneficiaries here. Corporations that have high leverage ratios, low retained earnings, high interest expense to earnings ratios, no cash overseas offset from repatriation, and those that have recurring long-term debt needs may be most at risk.

Other implications

While some argue that companies will try to raise outsized amounts of IG capital ahead of the deadline to lock in funding with the tax benefit before the loophole is closed, there is likely to be a provision in the legislation that would treat such debt as new debt. In our Investment Grade Strategist Hans Mikkelsen’s view, demand for IG credit could materially reduce over time. The tax change could also dampen Leverage Buyout (LBO) activity, according to our High Yield strategist Michael Contopoulos, where these funds are already struggling to generate high returns – note that LBO funds are currently sitting on close to $1tn in cash looking for a home, according to Preqin’s third quarter update.

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