In writing about tech companies like INTC and AAPL, I’ve been struck by the large amount of cash these firms, virtually debt-free, have on their balance sheets. I’ve also been surprised–even though I knew in general terms it was the case–how little of their profits are now coming from the US. (True, some companies like INTC make components in the US that they ship abroad to device manufacturers who sell their finished products back to US customers. So what appears as foreign revenue to INTC is actually a function of domestic demand. But this is not as big a phenomenon as it was, say, ten years ago.)
That got me thinking about the four items listed in the title above, taxes, eps, dividends and cash–because they’re all interconnected.
One salient feature of today’s stock markets worldwide is that investors seem to me to care only about after-tax earnings per share. They have no interest in the rate at which those earnings have been taxed.
Hasn’t it always been like this? No. When I came to Wall Street in the late Seventies, analysts routinely noted in their reports if a firm’s tax rate was below the statutory norm in the US. Also, when thinking about price earnings ratios investors mentally adjusted earnings to what they would be if fully taxed.
When I first saw UK research in the mid-Eighties, I was surprised to see that the historical income statement series in them always featured earnings “normalized” to the statutory tax rate in the home country of the firm, not the (almost always lower) actual tax rate paid. Analysts only went to the trouble of doing this because the normalized figures were the ones their customers wanted to see.
What made it this way?
1. Different times, different customs.
2. UK investors then were intensely focused on a company’s dividend-paying power (more about this below). In my experience Wall Street has never been anywhere near as concerned about dividends as the British, but a generation ago it was certainly much more interested in income than it is today.
3. Investors believed–incorrectly, as it turns out–that a low tax rate was a temporary phenomenon, something like earnings growth achieved through cost-cutting, that should be factored out of the profits being capitalized (a fancy term for having a pe applied to them to determine a stock price).
foreign earnings and dividends
Take a US firm (really any firm with a high home country tax rate) that makes money in a low tax rate country abroad and repatriates the funds to the US. When it does so, it owes Federal tax at 35% on the money, less a credit for any tax paid overseas.
This may entail a substantial haircut to the funds brought back to the home country. For example, if $3 in profits have been taxed at 0% in Hong Kong, when the money is brought back to the US, the company is left with $1.95. (What about state taxes?–companies routinely repatriate through states like Nevada that have no income tax.)
But any money used to pay a dividend to US shareholders has got to be in dollars at a US financial institution (ever tried to cash a foreign-currency check at a local bank?). In other words, the money has to either result from profits earned in the US or to have been repatriated, and given a potential buzz cut.
So, if you’re principally interested in dividends, a low tax rate may be a warning sign.
the 2004 amnesty
Then there’s the amnesty question.
Normally, in order not to return foreign earnings to the US, corporations have to tell the IRS that the money is permanently invested abroad (Citigroup’s “Doomsday” plan [my name] to use up its tax loss carryforwards is to reclassify many billions of dollars of foreign profits now classified as permanently invested abroad and temporarily return them to the US–see my posts on Citi and Mike Mayo).
In 2004, however, as part of the American Jobs Creation Act, Congress declared a temporary exclusion of 85% of the tax due on repatriated earnings, as a way of stimulating economic growth here. Stimulative or not, a ton of money was brought back from abroad, presumably because it was only taxed at 5.25%.
From time to time, the topic is brought up again. One of the main counterarguments is that if we make a habit of periodic amnesties, firms will simply wait and never repatriate anything. They’ll even borrow to fund spending plans here. But they do this anyway (support is buried in this very interesting academic paper).
foreign earnings and eps growth
Given the maturity of the US and western European economies, as well as the severe body blow that the big banks have delivered to them through the financial crisis, it seems to me that the more exposure an investor has to emerging markets (subject to the amount of risk your financial situation and your blood pressure allow) the better. So what follows is not a knock on having money in Latin America or the Pacific.
For many people, the best way to do this will be to own US-based multinationals, ranging from AAPL and AMZN to MSFT and INTC. If so, it’s important to keep in mind that there’s a certain “phantom” aspect to the rate of earnings growth these companies are achieving. This is not a key investment consideration today, just something to keep in the back of your mind.
Let’s take a company that earns $400 pre-tax, all in the US, and taxed at 35%. After-tax income is $260.
Assume that some years later the same company still earns $400 pre-tax, but that half of that profit is recognized in Hong Kong. What is the net? $200 x. 65 = $130 (the US portion) + $200 x 1.0 = $200 (the HK portion), which equals $330.
The second number is 27% higher than the first. If the transition happened over 10 years, that would be an addition of 2% to the annual growth rate. That’s probably not so important. But, if for some reason the company had to repatriate its current and future Hong Kong earnings, that would effectively be about a 22% drop in the level of eps. That would be.
It seems unlikely to me that external events would force a firm to repatriate foreign earnings. More plausible is the possibility that as the Baby Boom ages, dividends will once again become important to investors (I think this is already starting to happen) and that they would therefore begin again to mentally decrease the pe multiple they would pay for unrepatriated profits.
That’s it for today. The rest tomorrow.