A U.S. Corporate Tax Cut is Not Priced into Stocks

by Geoff Gannon


I’ve noticed that in a lot of the emails I’ve been getting recently, the emailer says something along the lines of “of course a U.S. corporate tax cut in 2018 is probably already priced into stocks”.

It’s not.

 

The Stock Market is Expensive

Stocks markets around the world – and in the U.S. especially – are very expensive right now. They’re overvalued. And no corporate tax cut being discussed would get close to increasing after-tax earnings enough to bring the normalized P/E on the overall market down to a normal level.

So, stocks generally are overpriced now before any tax cut and will still be overpriced after any corporate tax cut.

However, that’s not what matters to a stock picker. A stock picker chooses individual stocks. Factors like the price level of the stock market or the effective tax rate of the S&P 500 are irrelevant to a stock picker.

To a stock picker: it’s the prices of individual stocks and the taxes paid by those individual stocks that matter.

 

U.S. Stocks that Pay Higher Taxes Than Foreign Peers Aren’t Rising Faster Than Those Peers

The easiest comparison to make is between the big 5 advertising agency holding companies: Omnicom (U.S.), Interpublic (also U.S.), WPP (not U.S.), Publicis (not U.S.), and Dentsu (not U.S.). This is the easiest comparison because the 5 companies are comparable businesses and they are headquartered in different countries – yet they are all “multi-national” in the sense of where their profits come from.

If the market has already priced in a U.S. corporate tax cut – the EV/EBITDA (“DA” is rarely anything more substantial than an accounting charge at advertising companies) – of the U.S. ad agency stocks (that’s Omnicom and Interpublic) should have been rising versus the EV/EBITDA ratios of WPP, Publicis, and Dentsu as a U.S. corporate tax cut looked more and more likely.

What actually happened this year?

Shares in the big 5 global ad companies moved as if these were identical securities. Investors showed no preference for one stock over another. They certainly didn’t start preferring the U.S. ad stocks – Omnicom and Interpublic – over ad stocks elsewhere in the world as we approached year-end.

In fact, I got several emails from people asking whether they should buy WPP instead of Omnicom because WPP is cheaper. None of those emails mentioned that – since the financial crisis – Omnicom has paid much more in taxes than WPP. This may indicate investors are not focused on future tax rates when considering which stock to buy in an industry.

 

The Highest Taxed U.S. Stocks Aren’t Rising Faster Than Other Stocks

Because investors often think in terms of P/E ratios and other after-tax measures (like EPS), another way a U.S. corporate tax cut could be “priced in” to stocks is for those stocks paying the highest tax rates (that is, those converting the least amount of EBIT into EPS) to rise the most in price. These are the stock where EPS will jump the most.

The best example of a high taxed stock is probably Village Supermarket (VLGEA). This company makes all of its profits from supermarkets in the high-tax country of the U.S. and basically all of its profit from supermarkets in the high-tax state of New Jersey (I don’t believe the couple stores outside New Jersey are money makers – though the company doesn’t explicitly break this out).

Village has paid a tax rate of 41% in 13 of the last 15 years. In the other two years, a tax dispute was resolved (against the company) in a way that caused it to book an 83% tax rate in one year and a 26% tax rate in the following year. Altogether, this means the company has been paying a 41% tax rate for at least 15 years.

Because Village is subject to both U.S. and New Jersey taxes on all its profits – it’s an extreme example. But, U.S. supermarkets as a group are highly taxed versus peers. Here is a comparison of how two U.S. supermarket stocks (Village and Kroger) have performed versus two U.K. supermarket stocks (Tesco and Morrison’s). The U.S. supermarkets pay high taxes (that might soon be lower). The U.K. supermarkets pay lower taxes that will presumably stay the same.

How have these stocks traded this year?

Here, it’s notable that these stocks seem to trade more on national – or even international headlines – than on factors that are more determinative of near future earnings per share (like what tax rate they will pay).

The sudden moves are in Kroger and Tesco and probably relate more to Amazon than to taxes.

How likely is it that Amazon buying Whole Foods will have a bigger impact on the financial results of Kroger than what the U.S. corporate tax rate is?

It’s also notable that, in a given month, the two more famous stocks – Kroger and Tesco – sometimes show at least as much similarity with each other as they do with the same-country peer I’ve matched them off with. For example, it’s Tesco and Kroger that have been racing up in price as we approach year-end. Only one of these stocks (Kroger) may be on the verge of getting a big tax break.

Finally, it’s worth noting there is a theoretical difference in how tax cuts should affect firms in different industries. In the long-run, a corporate tax cut may benefit supermarket owners only partially and the rest will go to shoppers. In the ad business – this won’t be true. When an ad agency pays lower corporate taxes this benefits no one but the ad agency.

 

How Messy Would a Corporate Tax Cut Make the Statements of U.S. Public Companies?

This is an email question I got a couple times this year. The long answer is technical. The short answer is…

Pretty messy.

U.S. public companies show both tax assets and tax liabilities on their balance sheet. The valuations put on these lines use the current tax rate as an input. The exact guideline is as follows:

“…using the enacted tax rate expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.”

Therefore, a change in U.S. tax rates will change both the amount shown for tax assets and tax liabilities. The tax assets will be reduced and the tax liabilities will also be reduced (in other words: the balance sheet will shrink). For many companies, the net result will be small.

However, almost every public company in the U.S. has some net tax asset or net tax liability on its books (they don’t cancel out). And how much of a deferred tax asset compared to a deferred tax liability a company has is not evenly distributed by industry. For example, capital intensive industries (like utilities) tend to have large deferred tax liabilities. Meanwhile, firms with large deferred tax assets aren’t really industry specific – instead they come in two flavors:

1)      Companies with large net loss carryforwards

2)      And companies with large employee benefit obligations

Of interest to value investors: it’s possible that some companies that now show up as net-nets may drop off the net-net list – if and when there is a change to the U.S. corporate tax rate.

And of interest to all investors: changes to tax assets and liabilities pass through the net income statement rather than just the comprehensive income statement.

This means that any company that wants to present its EPS to you as if the tax rate was the same in 2018 as it had been in 2017 will have to present you with two “adjustments” to reported earnings:

1)      They will have to tell you that the tax rate was “X” this year and “X plus Y” last year. In other words, they will have to tell you how much they benefited purely from paying less taxes. This, of course, is expected to be a benefit they keep enjoying in the years to come.

2)      More confusingly: they would also have to discuss changes in balance sheet items that pass through the income statement. So, they will have to say something like “our change in the assumed tax rate decreased our tax assets by $1.7 million and decreased our tax liabilities by $1.3 million which, on a net basis, caused a $0.4 million reduction in our reported net income for the quarter.”

Public companies that do investor days, earnings calls, press releases, etc. will likely be very explicit about all this. They will pretty much hold analysts’ hands and tell them what EPS number to use – and it won’t be the reported EPS number.

But, there are other public companies that just dump all this in disclosures. There are U.S. companies – often smaller and sometimes family controlled – that disclose everything but explain nothing.

It’s these less well-covered stocks you should be focusing on in the wake of any U.S. corporate tax cut. Watch those stocks whenever they first release quarterly results that include the impact of any changes in the corporate tax rate. In the hours and days right after they report that quarterly result – the stock may be temporarily oddly priced.

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