Author's update, January 1, 2019: The original article erroneously stated that Apple's deferred taxes would affect future net income. However, those deferments have already been claimed on previous income statements. The article now states that they will affect future cash flows only.
Much media attention has been given to the Tax Cuts and Jobs Act that was signed into law in late 2017, but few articles have informed investors on what this means for the stocks they hold and how stocks should be evaluated. Individual investors do not always have time to dig into financial statements and often rely on ratios on popular finance web sites as a shortcut to screen stocks or evaluate businesses. This article will show how the tax act may affect the conventional valuation and dividend ratios for large American companies with cash overseas that may be affected by repatriation.
The Tax Plan
The crowning achievement of the Trump plan was a reduction of the standard corporate income tax rate from 35% to 21%. This has the potential to increase the bottom line for U.S. companies over the next few years.
Another benefit that the act offered to U.S. companies is a one-time rate for repatriation of cash held overseas. Companies would normally pay a 35% tax rate to repatriate cash, and they would often hold cash overseas to avoid doing so. President Trump offered companies rates as low as 8% for a limited time to encourage bringing those funds back into the country.
Large companies that receive most of their sales from overseas had an opportunity to reduce how much they will pay for the repatriation tax, but only for a limited time. This means companies face a potential one-time expense that could affect their 2018 earnings. Let's look at how two companies handled the repatriation tax and how it affected their net income.
Kicking the Can Down the Road
At the time the law passed, Apple (AAPL) had $252.3 billion in cash holdings overseas, more than any other U.S. company. Apple took advantage of the opportunity to repatriate foreign cash holdings at a lower rate.
Thanks to a lower income tax rate, Apple's effective tax rate for fiscal 2018 was only 18.3%, down from 24.6% in 2017 and 25.6% in 2016. Apple is the exception to the norm - which we will see in the next case - of effective tax rates increasing for 2018 due to one-time repatriation expenses.
The important thing for investors to be aware of with Apple is that it owes $34 billion in deferred taxes that were accrued leading up to 2018. Apple has contracted to pay $5.4 billion in 2020-2021, $5.9 billion in 2022-2023, and $22.3 billion after 2023. Those contracts are reported on Apple's balance sheet as part of its $45 billion in other non-current liabilities and detailed on page 34 of the 10-K for fiscal 2018.
Those deferred taxes have already been reported in earnings, so they will only affect future operating cash flow. Investors will need to factor that in when forecasting future cash flows.
Ripping Off the Band-Aid
Nike (NKE) took a different approach to repatriation. Nike paid $1.9 billion in one-time transition tax, increasing its effective tax rate from 13.2% in fiscal 2017 to 55.3% in fiscal 2018. Instead of kicking the can down the road, Nike paid it all at once, cutting its 2018 net income nearly in half.
The problem for investment analysis is that Nike has a one-time expense that decreased its net income for 2018 by 43.3%. Many of the most popular fundamental trailing twelve month ratios that investors use can be affected by that. Look at the current comparison between Nike and its biggest competitor Adidas (OTCQX:ADDYY):
|Net Margin (ttm)||5.66%||7.14%|
|Return on Equity (ttm)||21.96%||24.04%|
|Dividend Payout (ttm)||63%||34%|
It looks at first glance like Adidas is a more profitable company with a safer dividend that is available at a cheaper price. However, Adidas is a German company that had no special repatriation tax opportunities this year. They paid an effective tax rate of 33% in 2017 compared to Nike's 55.3% in fiscal 2018. Let's use some alternative ratios to account for Nike's non-recurring item:
|EBIT Margin (ttm)||12.4%||11.0%|
|Return on Equity (13-year median)||22.46%||13.27%|
|Dividends Paid/EBIT (ttm)||26%||22%|
Source: Adidas and Nike data from GuruFocus for ROE and EV/EBIT. Most recent 4 quarterly reports used to calculate EBIT Margin and Div/EBIT.
By taking the one-time tax expense out of the picture, these numbers paint a different picture of the comparison between Nike and Adidas. Let this be a lesson in the dangers of relying on the popular trailing twelve month figures for anything other than initial screening.
Use the above examples as a basis for evaluating current and future investments that may have been affected by the one-time repatriation tax offer this year. Check to see if the company's effective tax rate increased or decreased in 2018, and see if the company deferred any repatriation taxes to the future.
A quick text search of a company's annual report PDF for the term "repatriation" should lead investors to this information. If the affected annual report is not out yet, it may take a little digging through the year's quarterly reports to get an idea of how it was handled.
Especially when comparing a company to foreign competitors, consider using alternatives to the typical trailing twelve month ratios displayed on popular finance web sites. EBIT can be helpful in these sort of situations, but be sure to account for the fact that EBIT is not reported on a per share basis like net income is through EPS. That is why I used EV/EBIT in place of P/E. In place of the dividend payout ratio, I divided the total dividends paid on the cash flow statement by EBIT.
If I were doing a dividend discount model to value Nike, I might add back in the 43.3% repatriation tax difference to net income to calculate a custom payout ratio for 2018. This would be more accurate than dividends/EBIT, which is only useful for comparing Nike with competitors. The same would go for any ROE valuation models that use net income or the dividend payout ratio.
The one-time repatriation deal has been good for large U.S. companies and their shareholders. However, as we approach earnings season, investors must be aware of its potential affect on net income and the ratios derived from it. Overlooking deferred taxes could result in overestimating the intrinsic value of a stock you are buying, and ignoring the effects of one-time payments could result in failing to notice good investments that don't pass your screens because of temporary low earnings. Ratios and valuation models are amazing tools for value investing and dividend investing, but they are not perfect, and sometimes we need to make adjustments to make more accurate estimates of the value of the companies we buy and hold.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.