Tax Cuts and Portfolio Impact

Tom Macpherson

The avoidance of taxes is the only intellectual pursuit that still carries any reward.”

  • John Maynard Keynes

The people are hungry: It is because those in authority eat up too much in taxes.”

  • Lao Tzu

Over the past few months there has been a great debate on what the reduction in corporate tax rates (from 35% to 21%) will mean for corporate earnings. Some companies such as Wal-Mart have already made commitments to sharing potential savings with employees. Before I discuss the impact on some of my holdings at Dorfman Value Investments, it might be good to review some facts about corporate tax rates and receipts.

  • Corporate share of federal tax revenue has dropped by two-thirds in roughly 60 years — from 32% in 1952 to roughly 10% in 2016.
  • Fortune 500 corporations paid an average effective federal tax rate of 23.4% from 2008 to 2016.
  • S. corporations hold roughly $2 trillion in profits offshore that have not yet been taxed here in the US.

A couple of things jump out from these statistics. First, corporations have played a steadily decreasingly role in federal government funding. The reduction in tax receipts over the past 60 years has dramatically impacted federal budgeting and spending. If the federal government doesn’t get revenue from private corporations, it must make it up with higher rates on individual tax payers, reduce overall federal spending, or take on an increasing amount of debt to pay for outlays (the latter has been the chosen path so far). Second, because many companies have never paid anything like the 35% rate, the impact of the tax cut will provide a relatively modest bump to companies’ earnings.

As an investor, I generally like any action by the government that allows my portfolio holdings to reinvest an increased amount of capital in their business. By focusing on companies with high returns on invested capital, even the smallest increase in free cash flow can make a significant difference in long-term value compounded over time.

Some Working Examples

How the tax cuts will impact individual companies is dependent upon their capital structure, business operations, R&D, etc.  Below, I take a look at two companies in my portfolios at Dorfman Value to demonstrate these differences. A quick note: with the new corporate tax rate at 21%, I have spent considerable time calculating the impact on earnings for each of my portfolio holdings.  Of my 19 holdings, roughly two thirds will see an increase in earnings. The remaining one third will see little to no impact.  For these examples I didn’t take into account any additional policy changes on cash repatriation, deprecation, etc. These represent an additional layer of complexity beyond the scope of this article.

Skyworks Solutions (SWKS)

For Skyworks Solutions, the past five years tax obligations can be seen in Figure 1. In most years, Skyworks was already paying less than the new rate of 21%. The overall impact on corporate earnings going forward will b e negligible. Total tax paid would be reduced by 0.01% under the new rate.

Figure 1: Taxes under previous rates

To better understand the impact, I’ve included a chart showing the taxes Skyworks would have paid under both the old tax law (for 2012 – 2016), and the new one, and the impact on net income by percentage.

Figure 2: Impact of Revised Tax Rate

The change in tax law would have had a minimal impact on Skyworks’s earnings. For the numbers that I watch like a hawk – free cash flow – the company would have seen only a minute reduction. Using a 21% tax rate, Skyworks would have generated roughly 99.99% of its actual cash flow from 2012 to 2016.

General Dynamics (GD)

Not all companies are the same. Looking at General Dynamics, the numbers look quite different. For the years 2012 – 2016 GD’s tax provisions are shown in the table below. Its effective rate was less than 35% most years, but way above 21%.  Accordingly, the cut to 21% will have a significant impact on the company’s bottom line.

Figure 3: Taxes under previous rates

On average, the reduced tax rate would have generated $300M in savings for General Dynamics annually over the four-year period of 2013 – 2016. (The year 2012 had significant variance due to write offs and was excluded from the analysis). The 21% tax rate would have produced $1.3B in savings and an average 25% reduction in taxes. Nothing to sneeze at there.

Figure 4: Impact of Revised Tax Rate

Conclusions

I have a tendency to not focus too much on macro-events in the economy. In general, I find issues such as which political party controls Congress or new accounting rules have little impact over the long-term. That said, there are two issues that can greatly affect a company’s valuation – tax rates and interest rates. In the case of the markets in 2018, I expect that rising interest rates will offset some of the benefit of the new tax law, but putting them together should still be a net positive in most cases. Investors would be wise to run a quick analysis on their portfolio along the lines discussed in this article.  The change in the tax regime could make some stocks affordable that were not before, or make some of your current holdings more expensive. Either way, a good investor will be able to see the overall impact and make decisions accordingly.

As always, I look forward to your thoughts and comments.

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