Category Archives: Accounting

US corporate tax reform: stock market implications (i)

November 21, 2016 By in deferred taxes, income tax rates, Uncategorized Tags: , , Leave a comment

high US corporate taxes

The headline rate for US federal tax on corporate profits is 35%.  That’s higher than just about anyplace else on the planet and, in itself, a deterrent to business formation in the United States.  It’s also the reason for the big business of advising corporations on how to finesse the tax code that has sprung up over the past decade or so.  In addition, it’s also why tax havens such as Ireland, Switzerland, Hong Kong and assorted islands in the Atlantic Ocean have become so popular with Americans.

A generation ago, world stock markets paid particular attention the rate at which a given company paid corporate tax.  The assumption back then, which has turned out to be incorrect, was that a firm could only sustain a low tax rate for a limited period of time.  So no matter what the rate shown in the financial statements, professional securities analysts would “normalize” it  to the top marginal rate.  Portfolio managers wouldn’t pay a full price for a low tax payer, either.

Not so in today’s world.  As far as I can see, Wall Street has long since stopped believing that the “quality” of earnings taxed at below the statutory tax rate is less than those same earnings taxed at a higher one.

Trump’s proposed reform

Given that the Republican party controls both houses of Congress and the presidency, it seems to me that the corporate tax reform championed by Donald Trump has a good chance for becoming law.  This would mean that for a company having $100 in fully-taxed pretax US income, after-tax profit would rise from $65 to $85–a 30+% boost.

big stock market implications

A change like this would have enormous implications for US-traded stocks.  In particular:

–investor interest would rotate toward purely domestic companies.  This would favor mid- and small-caps over large, and dollar earners over multinationals.  I think this is already starting to happen

–to the degree that they could be, elaborate tax avoidance schemes that have become common for US firms will be unwound.  Tax havens will suffer.  On the other hand, profits from future earnings that would otherwise be held in tax-haven banks will begin to be repatriated to the US.  Trump is also proposing to allow money now “trapped” in tax havens to be brought back to the US on payment of a 10% income tax.

–tax inversions by US-based companies–that is, flight of high-rate US taxpayers to tax havens abroad (or, actually, just about anywhere else) will come to a halt.  Arguably, companies that have recently inverted may begin to trade at discounts to un-inverted peers

–the price US firms would be willing to pay for foreign companies using funds parked abroad should fall

–it’s possible that US investors will begin to become interested once again in the ins and outs of the tax line on the income statement.  That might mean that 1980-style quality-of-earnings differentials will be in vogue again

–there are also possible negative implications for firms that have substantial tax loss carryforwards or who benefit from the many industry-specific tax preferences of the current tax code.

 

More tomorrow.

are high margins better than low ones?

October 28, 2016 By in contribution margin, margins, Retail, Uncategorized Tags: , , , 1 Comment

This post is indirectly about Amazon’s retailing business, although it has much wider implications.

My answer:  not necessarily.  It depends on what kind of company we’re talking about.  Note, also, that this is a topic that’s badly misunderstood, particularly in the financial press, which clings to the simple assumption that high margins, of themselves, are better than low ones.

 

The apparent virtue of having high margins is clear.  Companies that have, for instance, essential intellectual property protected by high patent/copyright/manufacturing-knowhow walls, can achieve selling prices that are much greater function of the usefulness of their products/services to customers than of their production costs (this latter is the functional definition of a commodity company).  Software firms can easily achieve 50%–or maybe 80% or 90%–operating margins for their wares.

 

Most distribution companies–both wholesale and retail–don’t work this way, however.  They thrive through low margins, high inventory turnover and careful working capital management to achieve superior financial results.  In fact, for these companies high margins are a threat, not a boon.  Why?    …because high margins attract competition.

the low-margin model

Here’s a (highly simplified) account of how the low-margin model works:

the simplest case

A warehouse holds inventory of $1 million.  It constantly replenishes its stocks, and pays cash immediately for new supplies, so that it always has $1 million invested.  It marks items up by 5% over its costs.

Let’s say the company generates an average of $525,000 in sales per month.  That means it turns over about half its inventory (a turnover ratio of 6x/year) each month, earning operating income of $25,000.  $25,000 x 12 = $300,000 in operating profit per year.  Applying a 1/3 income tax rate, it produces $200,000 in net income.  That’s a 20% return on invested capital. Not bad.

a more favorable one

Let’s now imagine that the company can turn its inventory once a month (turnover ratio = 12).  This means it earns operating income of $50,000/month, or $600,000 per year. This translates into $400,000 in net income. That’s a 40% return on capital.

nirvana

Let’s say the company turns inventory once a month but is large enough or important enough to suppliers that they no longer ask for payment on delivery.  Instead, they are willing to wait for 30-45 days.

Now the company has zero/negative working capital, i.e., no capital invested in inventory.  It’s return on investment is now infinite.

 

Yes, this third case is probably too good to be true.  But it illustrates the enormous, badly-understood, power of high inventory-turnover companies.

 

A post on potential troubles in paradise on Tuesday.

 

 

3Q2016 earnings for Tesla (TSLA): still a “dream” stock

October 27, 2016 By in cash flow/share vs. earnings/share, earnings conference calls, earnings surprise, Uncategorized Tags: , , Leave a comment

TSLA reported 3Q16 results yesterday after the New York close. The numbers were better than admittedly modest expectations:  the company sold a record number of cars: it had profits; cash flow was strongly positive–although flattered by better management of working capital and sale of pollution tax credits.  Still, a plus.  And the stock is up by about 4% in pre-market trading as I’m writing this.  (I should mention that other members of my family and I hold small positions in TSLA.)

The fact that a $30+ billion market cap company earned $22 million in a quarter would scarcely be considered good news under most circumstances.  Annualizing and rounding up to $100 million for a full year would imply a PE of 300x for the company’s stock!  However, TSLA is still to a considerable degree a “dream” or “concept” stock.

 

The prototypcial “dream” stock is a firm that starts up with the intention of prospecting for gold.  It makes what it thinks/says is a significant strike.  While the company creates the mine and associated processing facilities, speculation about the quality and extent of the orebody runs rampant.  After all, there’s no factual information to contradict any rumors that may float about.

Then the mine opens.  There are now facts available about ore quality and mining costs.  So there’s no more dream–only brass-tacks reality.  The stock typically peaks the day the mine opens.

TSLA’s case is an unusual one.  Auto production has been under way for some time.  Yet the stock hasn’t reverted to trading on actual results.  To some degree the dream has been dented–I find it hard to imagine TSLA could repeat today its 2014 convertible bond offering, whose conversion price was set at $350.  But Elon Musk has expanded and reset his aspirations for TSLA  often enough during its short life as a public company that at least some version of the dream remains alive.  Unless/until TSLA disappoints severely in its results, I’d think the stock will continue to trade without a strong connection to earnings for some time to come.

 

 

 

issues with the traditional business cycle picture

September 27, 2016 By in capital spending and the business cycle, economics, government economic policy, Uncategorized Tags: , , , , Leave a comment

As I mentioned yesterday, one BIG problem with the traditional business cycle model (the one taught in business schools) is that although it explains what happens abroad, it no longer fits with behavior in the US economy–which is, after all, the biggest in the world (for believers in purchasing power parity, the second-biggest   …after China).

The model says that lower interest rates energize business capital spending, which produces new hiring, which leads to higher consumer activity as new employees spend their paychecks.

Makes sense.

the US experience

In the US, however, consumer spending recovers first.  Typically, soon after the Fed begins to lower interest rates, US consumers have been back in the malls, spending up a storm.  Rather than industry lifting the consumer, the consumer pulls industry out of its slump.

How so?

Economists theorize that what’s at work in the US is the “wealth effect.”  Two aspects:

–maybe lower rates are like Pavlov’s dinner bell ringing and consumers begin to salivate in advance of recovery  (my personal take on this is idea that the office/plant grapevine signals that the worst is over, that layoffs have stopped and new hiring will soon begin)

–lower rates = house prices start to rise, as do bonds and stocks.  So consumers feel wealthier as rates fall, because their accumulated assets (their wealth) are worth more.

The problem here is that we’ve had zero rates for eight years without seeing the traditional recession-ending spending surge

where’s the capital spending?

Whether capital spending is the locomotive or the caboose, it’s still arguably an integral part of the economic recovery train.  Why haven’t we seen a capital spending surge in the US?  Is the lack of capital spending an indication of continuing weakness in the US economy, as the traditional business cycle theory would suggest?

I think four factors are involved here, the sum of which suggests reality has sped far ahead of theory:

–the internet.   Typically, there’d be a surge in construction of shopping malls as recovery gains speed.  But as online commerce has developed, we’re finding that we already have maybe 20% too much bricks-and-mortar retail space

–globalization.  Continuing industrialization in emerging economies like China during the last decade has decisively shifted lots of low-end US-based manufacturing abroad.  In addition, I’m also willing to entertain the thought that crazy spending in China has produced an enduring glut of manufacturing capacity there, although I have no hard evidence

–software.  For many (most?) US companies, the largest target for new investment spending is not bigger, newer plants but faster, more efficient software. The National Accounts, the government system of tallying economic progress, have no effective way of recording this expenditure for analysis.  The traditional business cycle picture is similarly stuck in the world of fifty (or a hundred) years ago

–skilled vs. manual labor.   This is a thorny issue, and one I have strong opinions about.  Here, I think it’s enough to say that the traditional model doesn’t distinguish between a twenty-year old with a grade school education and a strong back vs. a college dropout like Mark Zuckerberg.  A generation ago, the distinction wasn’t important.  today, it’s crucial.

 

 

 

three ways to account for associated companies

July 27, 2016 By in Accounting, Nintendo, Uncategorized Tags: , , , , , , , 1 Comment

This post is to lay the groundwork for understanding what Nintendo actually said about Pokemon Go last Friday.

There are three basic ways to account for companies that a firm owns an interest of less than 100% in another firm.

–the cost method.  This is used when the firm whose financial reports we’re talking about has neither influence nor control over the operations of the enterprise held.  A good rule of thumb is that this means a holding of less than 20% of the outstanding shares.

In this situation, the holding is listed on the balance sheet as a long-term investment at acquisition cost.

Under normal circumstances, the income statement contains no accounting of the holding’s financial results.

Two exceptions:  dividends paid are recorded as income; if the asset is impaired, the loss is shown on the income statement.

On the other hand, if the value of the holding increases, there’s no reflection of this in the owner’s financials.  Yes, accounting theory says the holding value should be adjusted periodically for changes in the investment’s fortunes, but as a practical matter this is rarely done.

—equity interests.  This is where the holding firm is judged to have influence but not control over the entity held.  Typically, this applies to holdings that fall between 20% and 50% ownership of the investment.

If so, the owner records his share of the financial results of the holding on a single line toward the bottom of the income statement.  This line is called “Equity Interests” or something like that and is an after-tax aggregate of all such equity interests.

The holder also adjusts the balance sheet value for profits (up), losses (down) and dividends received (down).

—consolidation.  This is the case where the holding firm exercises influence and control.  The rule of thumb here is that ownership of 50% or higher implies having both.

If the ownership is less than 100%, the consolidating company still reports results–revenues, costs etc.–from operations as if it owned 100%.  But it add correcting, after-tax entries, both in the income statement and on the balance sheet, typically labelled “Minority interests” that subtract out the portion of earnings and assets held by others.  Again, these are aggregate figures and not broken out holding-by-holding.  Minority interests are usually recorded toward the bottom of the income statement, somewhere near the consolidated net income line.

Tomorrow, how this applies to the Nintendo announcement