Popular Earnings Analysis Method Just Got Considerably More Difficult

One of the biggest benefits to the new tax law was the one-time tax break companies would get for bringing cash being held overseas back to the United States. The effective rate on those repatriated assets was considerable and a number of companies have taken advantage of the tax break.

Companies like Alphabet, Apple, Intel, and Microsoft are taking advantage of the so-called transition tax and paying billions in taxes. Apple alone is paying $38 billion in taxes while Microsoft is paying $17.8 billion.

Fortunately for these companies, the new tax law allows them to take the charge against 2017’s earnings, but it allows them to pay the taxes over a set schedule over the next eight years. The plan calls for the taxes to be paid at eight percent for each of the first five years (40%), 15 percent in year six, 20 percent in year seven, and a final 25 percent payment in year eight. It should also be pointed out that the IRS isn’t assessing interest on this payment schedule. Don’t you wish you could stretch your tax payments out over eight years and not have to pay interest on them?

All in all, this seems like a win-win situation. The companies bring assets back to the U.S. for capital expenditures, stock buybacks, employee bonuses and pay increases, etc. The government gets to collect substantial taxes to help offset the deficit spending and the companies get a break for taking advantage of the new law.

However, one of the most popular ways of measuring the quality of a company’s earnings is to compare the cash flow to the earnings. This shows the company’s revenues from operations are strong enough to support future capital expenditures, continue growing the company, and pay any dividends. With this new tax structure and the payment schedule, the earnings were affected in 2017, but the cash flow wasn’t. Starting next year and for the next eight years, the cash flow numbers will be affected by the tax payments, but the earnings won’t be, and thus the issue of using this analysis method.

How big of a difference could this make? The Wall Street Journal featured an article on the transition tax and how it will impact earnings and cash flow. They used Microsoft as an example, showing that the company will pay $17.8 billion in tax, taking the charge against last year’s earnings. The cash flow for 2018 will be reduced by $1.424 billion and that should hold true for the next four years after this year. In 2023, the cash flow gets reduced by $2.67 billion. For 2024, the reduction is $3.56 billion and finally in 2025 the reduction is $4.45 billion.

This is a considerable reduction in cash flow when you consider that in the fiscal year ended in June ’17, Microsoft’s operating cash flow was $39.5 billion. We are talking about a 10-percent reduction in cash flow based on current numbers. Obviously investors are looking for the company to increase its operating cash flow over the next eight years, so that percentage could be much lower. But what if we go through a recessionary period like we did in 2000-2002 and again in 2007-2009?

Quite frankly we don’t even have to go through a recessionary period to see Microsoft experience a decline in operating cash flow. The company saw operating cash flow drop from $31.6 billion to $28.8 from 2012 to 2013 and it dropped from $32.2 billion in 2014 to $29.1 billion in 2015.

Trying to compare the year over year operating cash flow is going to be much more difficult for companies that took advantage of the one-time tax break and are paying the taxes on the eight-year schedule. Obviously with a company like Microsoft it should be a little easier to evaluate the earnings and make sure the comparison is valid, but with less-followed companies that took the tax break, it could be considerably more difficult to evaluate.

This situation could start impacting earnings reports as soon as April when we get to the next earnings season. Be prepared to see some odd reactions to earnings reports and possibly a greater amount of volatility surrounding the stocks that took advantage of the tax break. It might take investors a little more time to assess the quality of the earnings’ reports and we could see some delayed reactions to them.

About Rick Pendergraft

Rick has been studying, trading, analyzing and writing about the investment markets for over 30 years. He has worked for some of the largest financial publishers in the world and he has been quoted in the Wall Street Journal, USA Today, the New York Times and the Washington Post. In addition, he has been interviewed on Bloomberg, CNBC and Fox Business News. Rick’s analysis process includes fundamental, sentiment and technical analysis. Rick started college as an education major, wanting to teach economics, but eventually changed to majoring in Economics and received a Bachelor of Science in Economics from Wright State University. His desire to inform and educate people is at the heart of his writing.

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