Tax Reform And Its Effect On Small Cap, High Cash Flow Stocks

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Includes: AAPL, ARCC, CALF, GE, IWN, MAIN, OFS, RICK
by: Darren McCammon

Summary

How Tax Reform could benefit small cap, significant cash flow stocks.

The effect is different depending on whether the company is a C-corp or Pass-Through security.

Proposal 1: Lower the top corporate tax rate to 20% from the current 35%.

Business Tax Proposal 2, 3, 4, and a Conclusion will be available in part 2.

The most recently proposed tax reform package has a number of changes to both personal and business taxes. The business tax proposals are likely to most positively affect small-cap stocks with high cash flow characteristics. Stocks similar to what Cash Flow Kingdom focuses on. Let me explain why.

Pass-Through Securities:

Before doing so, however, I need to make sure readers understand the basics of what a pass-through security is and does, as well as why it is different than the more typical C-Corp. Simplified somewhat, pass-through entities (e.g. BDCs, MLPs, REITs, CEFs, Trusts, etc.) are those who do not have to pay corporate income tax, provided they distribute the majority of their taxable income, usually 90% or more, to shareholders. These companies and their distributions avoid double taxation (35% corporate taxes + 15 -20% dividend taxes) in return for almost all taxable income being paid out to shareholders as distributions. The receivers of these distributions then have to pay full marginal income tax rates (typically 28-50%+ currently) on what is usually a significantly larger distribution, instead of receiving the lower dividend tax rate status (15-20%).

Pass-through securities vs. C-corps

Such a situation can be particularly beneficial for those in low-income tax brackets (retirees), or anyone who can protect the large distributions from taxation via the holding being in a tax protected account like an IRA. While all small-cap companies with high cash flows are going to benefit from proposed tax reform, pass-through security benefits will be different than normal C-corp benefits.

The Proposed Business Tax Changes I would like to discuss are:

  1. Lower the top corporate tax rate to 20% from the current 35%.
  2. "Consider methods" to reduce corporate double taxation (potentially includes allowing an expansion of companies selecting pass-through status).
  3. Allow businesses' capital investments (excluding structures) to be immediately expense for a period of at least five years, rather than depreciating the value of those assets over time as under current law.
  4. Establish a top pass-through rate of 25%.

Tax law is a dry subject, however. So rather than submitting readers to one long boring article with a low retention rate, I will break it up into parts. Hopefully, that way eyes glazing will be kept to a minimum.

Proposal 1: Lower the top corporate tax rate to 20% from the current 35%

The United States has the third highest general top marginal corporate income tax rate in the world, second highest if you consider Puerto Rico as part of the US.

Source: Tax Foundation.org

This causes companies to very actively seek to avoid this relatively high tax rate by trying to recognize profits anywhere but in the US, and to studiously avoid bring those profits back into the US. Apple (AAPL) for instance may be a US company headquartered in Cupertino, CA; but the reality is they have a $257 billion-dollar cash hoard, almost all of which they keep out of the US for tax reasons. That’s not millions folks, that’s billion with a B, and it is just one company. Bloomberg estimates the top 50 companies in the S&P 500 have $925 billion-dollars stored outside the US. I don’t know about you, but when we start talking a trillion dollars, I know it is big, but I start to lose a grasp on how big. Here’s my favorite graphic to give you an idea what a trillion dollars in $100 bills look like:

They accomplish this by ensuring corporate headquarters are located in tax-friendly locations (inversions, Apple’s is in Ireland), building plants and transferring jobs to other countries (offshoring, Apple’s products are made in Mongolia, China, Korea and Taiwan), and setting up dummy IP companies in tax-friendly locations. Apple’s IP Holdco is Apple Sales International, and get this, it is a tax resident of NOWHERE and has never paid more than 1/10 of 1% in taxes in any single year. Basically, the idea behind these strategies is to have as little profit-making entities in the US as possible, and instead recognize those profits in more tax-friendly locations. You then want to avoid reinvesting those offshore profits in the US (repatriating) so as to keep them from being taxed here.

Large companies are willing to spend millions doing this, hiring some of the smartest specialists in the world to legally accomplish it, because they can save hundreds of millions or even billions in taxes. You can rant and rail all you want about trying to close “loopholes” but the simple fact is many of these aren’t loopholes. In many cases, they are legitimately moving operations overseas so as to avoid US taxes. Also realize trying to make a moral argument or apply moral pressure is basically a waste of time, political grandstanding. Companies don’t have morals and are never going to. Their job is to maximize profits for shareholders, and when they do anything less, we shareholders throw the bums who operate them out. Our politicians and Tim Cook can talk all they want, but it is just talk. You have to change the actual dynamic and incentives to change the result.

A high US corporate tax rate has had a significant and obvious negative effect on US jobs as it has encouraged more and more assets to be located, and work to be done, in locations with lower taxes than the US. Basically, anywhere but here. That, in turn, causes lower US income, and thus lower US income taxes. One could maybe argue that higher income tax receipts from this proposal, would be offset by lower business tax receipts, except that many companies, which due to multiple billions of dollars of business in the US, pay no effective tax anyway. General Electric (GE) for instance had a -4.5% US tax rate last year. So basically, for large multi-national companies, you are talking about either getting more income taxes by them creating more US-based jobs, or getting nothing.

That, however, is just for the large multi-nationals who can afford high-priced tax lawyers, overseas dummy companies, inversions, building plants in other countries, etc. Who really pays current corporate tax rates is small companies and family businesses. Smaller companies could technically take advantage of the same strategies; however, in reality most don’t. They just don’t have the knowledge and wherewithal to do so. Spending $1 million on tax lawyers to move profits overseas is viable for a billion-dollar company, but it’s not for Bond-Coat, Inc., Gulf Manufacturing, LLC, or HW Temps LLC, all companies Main Street Capital (MAIN) has made loans to.

A key thing to also note is these smaller companies also have a much bigger percentage of US citizens in their employ than large companies, and just as importantly they tend to invest, grow, and spend in the US much more than their larger counterparts. In financial terms, they are said to have a much higher US money multiplier or higher US-based velocity of money. US-based velocity of money is the frequency at which the average unit of currency is recycled, and used to purchase domestically-produced goods and services within a given time period. This is just a fancy way of saying any funds which go through these companies tend to be recycled into other US companies, employees, and entities. The point is corporate tax cuts primarily promote US-based growth, AND thus US-based income and sales taxes.

From our investor point of view, it is important to understand a business tax cut from 35% to 20% is going to mainly benefit the smaller companies I mentioned earlier who owe money to MAIN. The large corporations don’t pay any US corporate taxes anyway, nor do pass-through securities like MAIN. It will indirectly make MAINs investments more secure and likely to be paid back, but it does not benefit them directly. So while small-cap companies with significant cash flow characteristics are primary beneficiaries here, pass-through securities are not. They don't benefit directly from a lowering of the corporate tax rate because they don't pay it anyway.

The indirect benefit, however, will be felt to a varied degree even among BDCs. Cash Flow Kingdom holding Ares Capital (ARCC) tends to lend at the larger end of the BDC universe, so some of their portfolio companies may already have various tax-lowering strategies in place. Cash Flow Kingdom holding OFS Capital (OFS), on the other hand, tends to lend to the lower end of the BDC applicable universe so their portfolio risk improvement is likely to be relatively greater than ARCC's. As a matter of fact, since OFS tends to also get more warrants thrown in as a normal part of its lending activities than ARCC or MAIN, we can probably assume the change will benefit the book value of OFS more than ARCC or MAIN.

But, small-cap domestic companies, in general, will benefit more from this proposed tax change than large-cap companies or pass-throughs. This is likely why the Russell 2000 has tripled the performance of the S&P 500 since tax reform came back on the table.

It is also likely part of the reason why most pass-through security indexes have barely budged.

The details matter here, I expect certain specific small cap, high cash flow companies we specialize in at Cash Flow Kingdom will do particularly well if the proposal passes, while others are less affected. For example, RCI Hospitality (RICK) is a normal C-corp that owns nightclubs (a.k.a. strip joints) and breastaurants. It had a 33% tax rate last quarter. If instead, it had been able to pay 20%, the bottom line earnings would have increased by almost 20%%. Usually, all else being equal, a 20% increase in EPS, tends to result in a 20% increase in share price. This one proposal could, therefore, help RICK more than other publicly traded companies.

For those more interested in ETFs than specific company analysis and choices, US Small Cap Cash Cows (CALF), or even iShares Russell 2000 Value ETF (IWN) come to mind as being full of companies which should benefit.

Part 2 coming soon...

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Disclosure: I am/we are long ARCC, OFS, RICK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is not meant as financial advice or a recommendation as the author does not know your personal situation and therefore cannot make specific recommendations. The article is intended for educational purposes only.

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