The Tax Law Is About to Make Analyzing Earnings Trickier
February 12 2018 - 04:59AM
Dow Jones News
By Michael Rapoport
The new U.S. tax law could throw a monkey wrench into a method
many analysts and investors use to gauge the strength of companies'
earnings.
A provision of the tax overhaul enacted in December assesses a
one-time tax on companies' accumulated earnings from outside the
U.S. But while the tax is typically charged to companies' 2017
earnings, firms have the option of stretching the actual tax
payment over the next eight years, interest free.
That decision, which companies need to make this year, could
throw off the comparison of a company's earnings to its cash flow,
a traditional way of assessing earnings quality.
Investors like to see a company's earnings fully backed by the
cash its operations are generating. It demonstrates the company has
the money to pay shareholder dividends and invest in its own
future. But stretching out payments of the "transition tax" on
foreign earnings will muddy that comparison, accounting experts
say.
Many companies, including Microsoft Corp. and Johnson & Johnson, have already made the choice to stretch out the tax bill. That meant their 2017 earnings were reduced, but the year's cash flow wasn't, making it appear earnings were more fully backed by cash flow. Then, for the next several years, the companies' cash flow will take a hit, while earnings aren't affected, making it appear earnings are less backed by cash flow than they really are.
Microsoft, for example, says it will pay a transition tax of
$17.8 billion. That amount was assessed against last year's
earnings, but cash flow wasn't affected. But starting this year, it
will be. Under the law, companies can make payments over eight
years on a back-loaded schedule that puts the maximum burden, 25%
of the total, in year eight.
For Microsoft, that will cut as much as $4.45 billion off the
company's yearly operating cash flow, which would be a significant
portion of the $39.5 billion in operating cash flow Microsoft
posted in its most recent fiscal year that ended last June. A
Microsoft spokesman declined to comment.
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.
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.
There are yet other complicating factors. Apple Inc., for
instance, had previously accrued a big obligation for U.S. taxes on
foreign earnings, anticipating it would repatriate some of those
profits someday, so in effect it had already accounted for much of
the $38 billion in taxes it owes.
And some companies are also realizing gains from deferred tax
liabilities, which take less of a bite for a company now that the
U.S. has lowered its corporate tax rate.
It's also likely that companies' earnings and cash flow will
both rise by the time the bulk of the transition-tax payments
become payable. J&J is scheduled to pay about $10 billion over
the next eight years, implying a maximum yearly payment of $2.5
billion that would take a slice from the $21.6 billion it reported
in operating cash flow for the 12 months ended Oct. 1. A spokesman
said the company thinks an increase in its cash flow because of the
lower tax rate will help "offset" the tax payment by the time it's
due.
Write to Michael Rapoport at Michael.Rapoport@wsj.com
(END) Dow Jones Newswires
February 12, 2018 05:44 ET (10:44 GMT)
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