Why Trump's Tax Plan Will Make It Much Harder To Analyze Corporate Earnings

For years now, we've been writing about the deception, falsification and accounting manipulation that large corporates use to spin their earnings reports. We've pointed out how corporate executives, often unable to affect any meaningful improvement in revenues or profits, are increasingly resorting to stock buybacks to goose EPS to help them hit incentive targets that are now commonly required to unlock extra incentive pay.

In fact, as we pointed out in October, Goldman's forecast of fund flows for 2018 shows corporates will once again be the single biggest buyer of stocks - some $550 billion, to be precise.

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And now, thanks to a provision in the Trump tax bill that allows US corporates to pay a tax on repatriated cash and assets interest-free over a period of 10 years, reading earnings statements for many of the US's largest companies is about to become even more difficult for analysts, as the spaced-out tax payments that will distort a key metric of company valuation - a company's free cash flow.

Under the terms of the tax plan, companies must decide this year whether they want to pay the entire tax bill for their repatriation now, or instead stretch it out over ten years. Since the entire value of the tax (the "T" in EBITDA) will be incorporated into 2017 earnings - but the tax payment won't impact the company's free cash flow - as a result, firms will appear to generate more of their income from cash flows, as opposed to financial engineering - a quality that investors typically favor, per Wall Street Journal.

As the success of financial engineering causes the gap between GAAP and non-GAAP (engineered) earnings to swell - if one takes the average of the median DJIA median differences for the past 4 quarters (LTM), one gets  just over 14%  (and 15.8% if "normalizing" the latest quarter's data) - this is just one more factor that will make it more difficult for investors to ascertain the true financial help of some of the largest multinationals...

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The transition tax is being assessed on profits that US companies have generated overseas for years and held there, rather than having them taxed at the old US corporate tax rate of up to 35%. As part of the tax overhaul, the US is relinquishing its right to tax those profits and shifting to a “territorial” tax system, which will levy taxes only on profits generated in the US - but not before assessing a one-time tax on past earnings from the old system.

And WSJ explains, the distortion runs both ways: Initially, 2017 earnings will look like they were more dependent on cash flows than they really are. Then, during the following years as the companies pay the interest-free tax installments, cash flows will shrink, making earnings appear less dependent on cash flows...

The end result will make things more difficult for analysts, who will need to perform some reverse-engineering to make sure they're comparing apples to apples figures.

The disconnect between earnings and cash flow will force analysts and investors to do some reverse-engineering of company numbers to make sure they’re comparing apples to apples. If they don’t do so—or are unaware of the need to—they could be misled.

“This is something investors need to pay attention to,” said Sandra Peters, head of the financial-reporting policy group at the CFA Institute, which represents chartered financial analysts who work with individual investors.

The mismatch could be particularly important when analyzing companies whose operating cash flow is below their earnings.

Unsurprisingly, Apple, with its massive cash pile of nearly $300 billion, with more than $100 billion of that parked overseas, is paying one of the largest one-time "transition taxes" of $37 billion...

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...But all of those payments will be stretched over ten years according to a preset schedule...

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The distortions during the coming years will be greatest for companies where cash flows are smaller than earnings, making them appear less financially healthy than they actually are.

The mismatch could be particularly important when analyzing companies whose operating cash flow is below their earnings.

Mondelez International Inc., for instance, said when it announced fourth-quarter 2017 earnings in January that it had a $1.3 billion tax on its accumulated foreign earnings, payable over eight years. That suggests its highest annual payment would be about $325 million, or 13% of the $2.6 billion in operating cash flow Mondelez posted in 2017, an amount already short of its $2.9 billion in net income.

Similarly, McDonald’s Corp. had a $1.2 billion charge for the transition tax, suggesting it will pay a yearly maximum of $300 million if it pays over eight years. The company had $5.3 billion in operating cash flow for the 12 months ended in September, compared with $5.7 billion in net income.

A Mondelez spokesman said the company is “continuing to evaluate the accounting impact of the legislation.” A McDonald’s spokeswoman declined to comment.

The transition tax is being assessed on profits that U.S. companies have generated overseas for years and held there, rather than having them taxed at the old U.S. corporate tax rate of up to 35%. As part of the tax overhaul, the U.S. is relinquishing its right to tax those profits and shifting to a “territorial” tax system, which will levy taxes only on profits generated in the U.S.—but not before assessing a one-time tax on past earnings from the old system.

...Especially in light of last week's machine-driven crash, this news begs the question: Will the algorithms be able to adapt? Or will they send stocks lower on strong earnings and higher on weak earnings, creating plenty of opportunities for their human rivals who can quickly reverse-engineer the difference.