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Taxes- A Large Issue Looming

|Includes: American States Water Co. (AWR), AXLL, CRK, DNN, HOS, T, WWON

“Last year we made $112 million before taxes….except we don’t pay no taxes”

-from “Some Like it Hot”

Publicly held firms try their best to replicate the Mafia’s tax rate, but normally only get there if losses are involved. As such, taxes must be carefully scrutinized for its effect on cash flow and leverge.

CT Capital’s risk (equity cost of capital) model incorporates many tax variables, including both the effective (that reported to shareholders) rate and that based on the actual taxes paid.

On (and in my upcoming book, Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making) I have highlighted the difference and how investors will be given advance warning through examining changes to the tax accounts. We will continue to do so here.

The firms included in the Table below could have serious tax issues ahead, based on one such metric-its deferred tax liability.  We are isolating the deferred tax liability to bring to your attention how it is created and the possibility of a large future tax bill in the event the firm is unable to grow the base from which this liability is created. For example, Verizon Corp. (VZ) has a very large deferred tax liability which would certainly force it to pay considerably higher taxes if it were to stop the growth in its capital spending. Verizon, like many companies, also took advantage of bonus depreciation resulting from The Economic Recovery Act. In Verizon’s case, however, it appears over the upcoming few years, its deferred liability will be growing, although it does bear watching.

This liability has attracted the attention of investors, creditors, managers and accountants for a long time. At issue is the difference between the tax expense reported in the financial statements and the actual tax payment to the governmental authorities, including overseas. The two are different because of different tax treatments of items for tax and for financial reporting purposes. Some differences are permanent (i.e., they are not expected to reverse in the future) whereas others are temporary differences that are expected to reverse.

An example of a temporary difference is accelerated depreciation related to capital equipment, although it is applicable to any item for which deprecation is allowed, including livestock. Goodwill can either be a tax deductible expense or not, depending how it is created.

If a deferral is reversed, the financial structure (leverage ratios) are effected, including the possibility of a violation of a debt covenant. The deferred tax account can be a provider or user of cash if the tax rate were to change.

In the Table below we compare the deferred taxes on the balance sheet, which represents the accumulated tax deferrals due to timing differences between the reporting of revenues and expenses for financial reporting and tax purposes, with shareholders equity. All the firms in the Table have a deferred tax liability at least equal to 10% of their stated net worth.

Also shown are deferred taxes (which represents deferred income tax expense reported in the Operating Activities section) which is compared to total cash flow from operations. All the firms in the Table have seen their recent operating cash flows boosted by at least 10% due to deferred taxes; thus in our estimation such reported cash flows are overstated, given these firms have reported negative free cash flows.

There are many firms which will see their tax bills rise due to a reversal of this liability-not just those on this small table-and so this issue must be analyzed in detail as it represents real cash going out the door. After all, this cash must come from somewhere- bank account, additional borrowing, sale of assets or stock, etc.

I bring this issue up, as with a slowing economy, many firms will look to cut back on capital spending, which is the primary force behind the increase in the deferred tax liability.

Also, with State budgets in havoc, corporations will find some of their tax incentives disappearing and new taxes introduced. Indeed, taxes will be a big issue for every firm over the coming years.

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Disclosure: No positions