By Nick McCullum
One of President Donald Trump's most notable campaign promises was the potential for repatriation tax reform.
A repatriation tax occurs when money earned overseas is transferred back to domestic accounts. This taxable event must occur before any money can be spent or invested domestically in the United States. Right now, capital that is repatriated from overseas subsidiaries is subject to the U.S. corporate tax rate of 35%. This has provided a barrier for companies that wish to bring foreign money home, and Trump has proposed a tax 'holiday' where this tax is reduced for a temporary period of time.
This article will discuss repatriation tax reform in detail and identify four companies poised to benefit from lower repatriation tax rates.
The Current State of Overseas Earnings
Right now, for companies to bring that money back into the United States and spend it domestically, they must be willing to pay the US corporate tax rate of 35%. While this is one of the highest corporate tax rates of any nation, companies do have the slight benefit of receiving a tax credit for any taxes already paid overseas.
For example, if Johnson & Johnson (NYSE:JNJ) earned $5 billion after taxes in Canada but paid 20% on those earnings, only a 15% (the difference between the U.S. corporate tax rate of 35% and the 20% paid in Canada) tax would be applied upon repatriation to the U.S.
This small tax credit has not been enough to trigger repatriation in general. By some estimates, American companies are holding $2.5 trillion of cash overseas, which is equivalent to ~14% of US GDP. This substantial amount of international capital is largely tied up in the US's largest companies.
Clearly, there are plenty of reasons (2.5 trillion, specifically) why the new presidential administration is considering implementing some form of repatriation tax reform.
This isn't entirely new ground. The next section will discuss the United States' most recent occurrence of repatriation tax reform and how it differs from today's current environment.
A Historical Basis for Corporate Tax Reform
The last time that the United States implemented repatriation tax reform was in 2004, under the George W. Bush administration.
U.S. corporations were permitted to repatriate overseas earnings at a temporarily reduced rate of 5.25%. Companies participate en masse, with 843 companies repatriating more than $300 billion.
While then-President Bush was hoping that the repatriated funds would be used to invest in U.S. infrastructure and the creation of new jobs, a large proportion of this money was used to fund share buybacks and dividend payments.
Trump's economic plan has suggested a one-time repatriation tax holiday which will tax overseas earnings at 10%. While this is nearly double the 5.25% tax imposed during President Bush's repatriation holiday of 2004, 10% represents a 25 percentage point difference from the normal U.S. corporate tax rate.
I believe it provides more than enough incentive for companies to repatriate the majority of their overseas funds.
For obvious reasons, this will be a huge positive for multinational companies. However, I am of the opinion that we will see a repeat of the behavior of 2004. Rather than investing in new plant, infrastructure, or R&D, I suspect that companies will use this new domestic capital to pay dividends and repurchase shares.
The next section will discuss the effects of a 10% repatriation tax holiday on four companies in particular.
Repatriation Tax Analysis: Apple
Apple (NASDAQ:AAPL) is the largest corporation in the world based on either earnings or market capitalization. They are a huge technology company with a wide variety of products, manufacturing cell phones, laptops, and tablets under the well-known names iPhone, Mac, and iPad.
Apple's success internationally has led the company to have massive cash reserves overseas. We can determine the approximate amounts by looking at the company's regulatory filings.
On page 55 of Apple's most recent 10-K, the company writes the following:
As of September 24, 2016 and September 26, 2015, $216.0 billion and $186.9 billion, respectively, of the Company's cash, cash equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S."
The key number to take away from this quote is $216 billion - the amount of overseas cash held by Apple in September.
Let's perform some analysis to determine how Apple would benefit if repatriation tax reform was implemented by the new presidential administration.
If Trump were to implement the 10% cash repatriation holiday, Apple would be able to bring home their $216 billion cash hoard while paying only $21.6 billion in taxes. The net effect would be an increase of $194.4 billion in Apple's domestic cash reserves.
If we compare this to the tax that would be paid under a normal 35% corporate tax rate (which would be $75.6 billion), Apple will realize immediate cost savings of $54 billion compared to repatriation under normal circumstances.
The numbers are similarly favorable on a per-share basis. Right now, Apple has 5.32 billion diluted shares outstanding according to their first quarter consolidated financial statements.
Some basic math determines that a repatriation tax holiday would provide Apple shareholders $10.14 of tax savings on a per-share basis. With Apple stock currently trading at $132.12, these per-share tax savings represent 7.7% of the company's current stock price, which shows the substantial effect of repatriation tax reform on Apple's balance sheet.
Savings aside, Apple would also need to decide what to do with their new $194.4 billion in domestic capital. Fortunately, they have plenty of options. One of the most obvious is to pay down debt.
Since Apple cannot repatriate cash without triggering a significant tax bill, the company has been funding dividends and share repurchases by issuing cheap debt before interest rates continue to rise.
The company's current debt situation could be summarized as follows:
- Total current liabilities: $84.1 billion
- Total long-term debt: $73.5 billion
- Total liabilities: $198.8 billion
There are a few things to note here. First of all, Apple's $194.4 billion addition to their domestic cash is nearly enough to pay off the company's total liabilities. It follows that the company could comfortable pay down either their current liabilities or their long-term debt.
So, Apple could completely transform their balance sheet by shedding their liabilities. However, I think this is unlikely to happen because of the low interest rates that Apple pays on their debt. The company also has a favorable debt maturity structure, with most of the company's debt lying at the long end of the yield curve.
Source: Apple 2016 10-K, page 60
I believe that buying back stock provides a better alternative. Not only do share repurchases boost per-share earnings, but they also create dividend savings for the company. Every share repurchased means one less stream of dividend payments to be paid later.
For Apple, in particular, it makes sense for the company to repurchase stock because they typically pay a higher dividend yield than the interest income they receive on their cash. On page 27 of Apple's 2016 10-K, the company writes:
The weighted-average interest rate earned by the Company on its cash, cash equivalents, and marketable securities was 1.73%, 1.49% and 1.11% in 2016, 2015 and 2014, respectively."
Given that Apple's dividend yield is currently 1.73% (which is depressed because of the stock's recent run), the company's dividend savings from repurchasing stock will provide the same return as leaving the capital invested in cash equivalents and marketable securities with the added bonus of boosting per-share earnings.
The cost savings from repurchasing stock will increase exponentially over time for Apple as the company continues to raise their dividend. Apple's dividend has grown at a rapid rate since the company began making payments in 2012, and it is highly likely that the company will continue to raise payments moving forward.
The true value of Apple's repurchased shares will be seen years down the road, when the yield on cost of repurchased shares is in the double digits.
One last option for Apple's new repatriated cash is acquisitions. Given their size, it is no surprise that Apple is active in the M&A arena - the company often scoops up budding technology companies and integrates their products into the Apple ecosystem. One notable example is Siri, which Apple acquired for $200 million in 2010.
If Apple decides to use repatriated capital for acquisitions, they will undoubtedly target companies with a similar focus and culture.
Recently, Baird analyst William Power has speculated that Tesla Inc. (NASDAQ:TSLA), Netflix (NASDAQ:NFLX), and the Walt Disney Company (NYSE:DIS) would all make attractive acquisition targets for Apple. While the thought of combining any of these companies with Apple is exciting (particularly Disney), it goes against Apple's history of much smaller transactions.
Whatever Apple decides to do in the light of a tax repatriation holiday, there is a high probability that it will be beneficial to shareholders.
Repatriation Tax Analysis: Microsoft
Microsoft (NASDAQ:MSFT) is a large technology company and the largest software company in the world. Its products are everywhere - most notably Microsoft Office and the Windows operating system.
The company also manufactures complementary products such as the Xbox gaming console and the Surface tablet.
Since Microsoft's products are used worldwide, the company's revenues are geographically diversified. This has led to substantial international cash reserves, as Microsoft does not want to trigger undue tax bills unless necessary.
We can determine the size of Microsoft's overseas cash hoards by examining regulatory filings. On page 42 of Microsoft's most recent 10-K, the company writes:
Of the cash, cash equivalents, and short-term investments as of June 30, 2016, $108.9 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects."
Running the same type of analysis that was done for Apple, we note that:
- Microsoft would pay $38.1 billion in tax to repatriate this capital under normal circumstances
- Microsoft would pay $10.9 billion to repatriate this tax under Trump's proposed repatriation tax holiday
The difference between these two sums is substantial - equating to cost savings of $27.2 billion. Taking into account the company's current 8.0 billion diluted shares outstanding, we note that these cost savings amount to $3.40 on a per-share basis.
Microsoft's current stock price is $64.00, which means that these per-share cost savings caused by a 10% tax repatriation holiday amount to 5.3% of Microsoft's stock price.
Cost savings aside, Microsoft would have the added benefit of a larger domestic capital base. By repatriating their $108.9 billion and paying a $10.9 billion tax bill, Microsoft will benefit from a $98.0 billion increase in their U.S. cash reserves.
There is a high probability that Microsoft will earmark some of this money to fund further dividend increases. Microsoft has grown their dividend at a rate of 17% over the past five years, which is a phenomenal rate of dividend growth. The company appears well poised to eventually become a Dividend Aristocrat - elite companies with 25+ years of consecutive dividend increases. You can see the list of all 51 Dividend Aristocrats here.
Microsoft could also deploy some of this capital to fund share buybacks. The company has been generous with stock repurchases in the past, announcing in September the intent to repurchase up to $40 billion of their float. Earmarking repatriated capital for this purpose would be consistent with Microsoft's previous capital allocation behavior.
Microsoft could also use these new funds to finance acquisitions. The company has shown in the past that it is not afraid to commit significant capital to acquisitions that it deems attractive. This was shown in 2016 when Microsoft paid $26.2 billion to acquire LinkedIn. Other notable Microsoft acquisitions include Skype & Nokia.
Regardless of what exactly the company does, investors can be rest assured that Microsoft's new domestic capital will be put to good use if a tax repatriation holiday is put into effect.
Repatriation Tax Analysis: General Electric
General Electric (NYSE:GE) is a large manufacturing company that is undergoing a significant transformation. GE investors will note that the company struggled mightily through the Great Recession, as the company's financing unit (GE Capital) nearly bankrupted the overall company.
GE is moving away from the financing business to focus on manufacturing. This will reduce the company's risk profile. The pro forma General Electric will generate less than 10% of its annual earnings from GE Capital.
Since the company is a globalized manufacturing business, many of their revenues come from outside the United States and this has led to substantial amount of cash being held in foreign subsidiaries.
General Electric has not yet filed their 2016 10-K, so the latest information we can glean is from the company's 2015 10-K, which describes its financial position as at December 31, 2015.
This information is displayed below. Please note that the company's current financial position may be considerably different since this information is more stale-dated than the information provided for Apple or Microsoft.
Source: General Electric 2015 10-K, page 80
By inspection, General Electric had $50.1 billion of capital sitting in the accounts of its foreign subsidiaries. While it's impossible to say for certain, I would suspect that these foreign capital reserves are higher today than when this report was filed. We note that:
- General Electric would pay $17.5 billion in tax to repatriate this capital under normal circumstances
- General Electric would pay $5.0 billion to repatriate this tax under Trump's proposed repatriation tax holiday
The difference in taxes paid due to the potential repatriation tax holiday amount to $12.5 billion. Further, General Electric reported 9.944 billion shares outstanding, which means these tax savings amount to $1.26 on a per-share basis.
Taking General Electric's current share price of $29.72 into consideration shows just how substantial these tax savings are. The per-share tax reduction is equal to 4.2% of General Electric's stock price.
By paying only $5.0 billion of tax on their overseas cash, the company would repatriate $45.1 billion. General Electric would likely do one of two things with their influx of domestic capital.
The first is share buybacks. General Electric's current dividend yield of 3.2% is well above the average dividend yield on the S&P 500 of 2.0%. This high yield means that the company will realize substantial cost savings in the form of reduced dividend payments from repurchasing the company's own shares.
The second form of capital allocation that General Electric will likely pursue in the event of a repatriation tax holiday is acquisitions. As an industrial giant with a $264-billion market capitalization, General Electric is a serial acquirer.
The company is constantly making acquisitions anywhere from the sub-$100 million range all the way up to a recent $32 billion transaction with Baker Hughes. General Electric integrates these smaller companies with their impressive distribution scope to generate cost savings and operational synergies.
Of the two options, I would prefer that General Electric devotes money to acquisitions since the company has already committed to $22 billion of share repurchases in fiscal 2017. Further, if acquisitions are executed correctly, the company will benefit from growth in absolute earning as well as earnings per share.
Repatriation Tax Analysis: Cisco
Cisco (NASDAQ:CSCO) is a global technology giant that provides services and solutions aimed at developing and connecting networks around the world. The company is highly diversified both operationally and geographically.
Approximately 40% of Cisco's total revenue comes from outside the United States. This generates pockets of overseas cash that the company does not repatriate due to the high U.S. corporate tax rates.
We can view exactly how much overseas cash is held by Cisco by examining their regulatory filings with the SEC. On page 58 of their 2016 Annual Report, the company stated the following:
Our total in cash and cash equivalents and investments held by various foreign subsidiaries was $59.8 billion and $53.4 billion as of July 30, 2016 and July 25, 2015, respectively. Under current tax laws and regulations, if these assets were to be distributed from the foreign subsidiaries to the United States in the form of dividends or otherwise, we would be subject to additional U.S. income taxes (subject to an adjustment for foreign tax credits) and foreign withholding taxes. The balance of cash and cash equivalents and investments available in the United States as of July 30, 2016 and July 25, 2015 was $5.9 billion and $7.0 billion, respectively."
In summary, Cisco held $59.8 billion in cash via their foreign subsidiaries but only $5.9 billion domestically. This is a stark contrast - the company holds ten times as much money in foreign subsidiaries as they do in their domestic corporate accounts.
As such, Cisco appears to be a prime candidate to benefit under the proposed tax holiday.
Running the same sort of analysis as before, we note the following with regard to Cisco's $58.9 billion in overseas cash:
- Cisco would pay $20.6 billion in tax to repatriate this capital under normal circumstances
- Cisco would pay $5.9 billion to repatriate this tax under Trump's proposed repatriation tax holiday
The difference between the normal taxation figure and the reduced amount is a staggering $14.7 billion. Considering that Cisco has a current market capitalization of $159.3 billion, this is a large sum even for a company as large as Cisco.
The numbers are also attractive on a per-share basis. The company reported total diluted shares outstanding of 5.09 billion when they filed their last 10-K (the same document that they reported their foreign cash reserves, chosen for consistency's sake).
On a per-share basis, then, the potential tax savings that would occur during a repatriation tax holiday would be $2.92. Given that the company's stock currently trades at $31.51, this is again about 9% of the common stock's value - a significant amount of tax savings for each shareholder.
Cisco's domestic entities would benefit from a net increase of $53.0 billion in their domestic cash levels. Like the other companies mentioned in this article, Cisco would have plenty of choices with regards to how they deploy this new domestic capital.
Instigating a new stock repurchase program is an obvious choice. Cisco currently has a dividend yield of 3.3%, well above the market's average yield, which means that the company could realize satisfactory cost savings by repurchasing their own stock.
Cisco could also use this capital to pay down debt by repurchasing their own instruments, although this likely wouldn't be as cost-effective as a stock repurchase plan.
Source: Cisco 2016 Annual Report, page 70
Cisco is also a serial acquirer (you can view their acquisition history here), but the acquisitions tend to be too small to move the needle on a sum of capital as large as $53.0 billion.
I would suspect that Cisco focuses most of this new capital on share repurchases.
Final Thoughts and Additional Resources
With the new presidential administration assuming position recently, the possibility of repatriation tax reform becomes greater all the time.
This presents an opportunity for investors. Purchasing stock in Apple, Microsoft, General Electric, or Cisco might be a profitable trade for those looking to take advantage of this trend.
However, investors should certainly not buy these companies purely as a way to profit off of repatriation reform. This is an example of short-term trading, and as we know great investors focus on the long term…
"The single greatest edge an investor can have is a long-term orientation." - Seth Klarman