Tax Reform Top of Mind for Wide-Moat U.S. Industrial Firms
Lower corporate taxes and higher infrastructure spending could cause our bull-case scenarios to play out.
Shares of diversified industrials have traded up in the aftermath of the U.S. presidential election, frothy with anticipation as a Republican-controlled Congress offers the possibility of business-friendly policymaking meant to revitalize a U.S. manufacturing landscape affected by globalization. This sentiment rang loud and clear at the 2017 annual outlook meetings of four U.S.-based wide-moat industrial titans representing over half a trillion dollars of market capitalization: 3M (MMM), General Electric (GE), United Technologies (UTX), and Honeywell (HON). While management teams enthusiastically highlighted corporate tax reform, capital mobility, and infrastructure spending as potential near-term earnings tailwinds, all stopped short of explicitly incorporating these favorable outcomes into 2017 expectations. We agree that it’s too early to include Trump’s America in the base-case assumptions that fuel our discounted cash flow analyses. However, if President Donald Trump’s target corporate tax rates and modest top-line growth materialize, our bull-case scenarios look realistic.
Election Jolts Market Sentiment From Low Global Growth to Overdrive
In our view, the positive reaction in diversified industrial stocks following the U.S. election Nov. 8 can be partially explained by some glimmers of hope following a particularly tough couple of years in the overall industrial economy. In late 2015, industrial management teams at their 2016 annual outlook meetings all sent the same cautious message: Low global growth is likely to persist, and it’s time to batten down the hatches. The late 2014 collapse in oil prices sent ripple effects throughout heavy industry, from the boomtowns surrounding U.S.-based shale plays to commodity-fueled emerging markets like the Middle East, Latin America, and China. As capital spending in these so-called high-growth regions slowed to a halt, diversified industrial companies saw organic revenue growth shrink from mid- to high single digits toward zero throughout 2015 and into 2016. For the past 24 months, we’ve observed industrial management teams brace even further for the realities of a low-global-growth environment, boosting earnings by cost-cutting as sales continued to dwindle amid weakened end markets.
Fast-forward to the annual outlook meetings conducted in late 2016 by wide-moat firms GE, Honeywell, 3M, and United Technologies, and the sentiment has shifted from pure caution to cautious optimism. As oil prices flirt with a bottom and signs of life emerge in developing markets, CEOs have greater confidence in the potential for stronger organic sales and ongoing earnings momentum in 2017; however, the common swing factors all have political origins. With a Republican-controlled Congress and a president who wants to “Make America Great Again,” corporate tax reform, greater capital mobility, and infrastructure stimulus are all possible outcomes that could help these U.S.-based firms reinvigorate their earnings growth in the near to medium term.
Corporate Tax Reform Could Boost Our Fair Value Estimates 10% on Average
At 35%, the United States has the highest federal statutory income tax rate in the industrialized world, a dubious distinction that highlights tax efficiency as one of the most complex and crucial functions of the corporate treasury in a diversified industrial firm with multinational operations. General Electric highlights in its 2016 10-K that it files over 5,500 income tax returns in 300 global taxing jurisdictions, a monumental yearly task that underscores the firm’s sophistication when it comes to tax management. While GE’s industrial business generated over $100 billion in revenue and close to $11 billion in pretax operating earnings, the company owed only $1.5 billion in taxes in 2016 at an effective tax rate of 13.8%. However, maintaining the disparity between 35% and GE’s most recent five year-historical average of approximately 22% involves permanently reinvesting earnings overseas, leveraging foreign tax credits, qualifying for U.S. business credits as a large U.S. employer or environmental steward, managing operating loss carryforwards, and above all, investing in people and resources to continually develop the decidedly nonindustrial core competency of tax management. Presumably, the cost of keeping all of this up eats away at some of the tax savings through higher corporate expenses, which could ultimately be simplified and subsequently allocated to other productive assets meant for expanding the business.
To some degree, all U.S.-based multinational firms do the same complicated dance, which explains the enthusiasm expressed by all the management teams for some form of corporate tax reform. All four companies pay effective tax rates that are substantially lower than the 35% statutory rate, mainly because of significant amounts of foreign business. Nevertheless, we expect that any additional tax relief would still probably have favorable impacts on our fair value estimates.
The foundation of Trump’s preliminary tax plan includes cutting the corporate tax rate from 35% to 15% and allowing U.S.-based manufacturing firms to choose between interest expense and capital expenditure deductibility from taxable income. The difficulty in simulating the impacts of the latter stems from a lack of disclosure regarding the geographic dispersion of capex from year to year. Since Trump has been so vocal about revitalizing U.S. manufacturing, we assume that only U.S.-based capex will qualify as a deduction against taxable income. If so, then it’s quite possible that the delta between U.S.-based capex spending and interest expense could be immaterial or even unfavorable. For example, United Technologies had $824 million of interest expense in 2015, but reported over $1.5 billion in capital expenditures. Approximately half of the company’s long-lived assets reside in the U.S.; thus, if we assume that half of United Technologies’ capital expenditures could be allocated to the U.S. and qualify for a deduction, then this would equal approximately $750 million. This amount is less than United Technologies’ current interest expense of $824 million. As such, it is more favorable to keep the interest expense deduction in this case.
That said, even in a crude analysis that ignores all other tax credits, Trump’s proposed 15% tax rate on U.S.-based corporate earnings would increase our fair value estimates for the four-company peer group by 10% on average. In deriving the new blended tax rates, we kept the 2015 ratio of U.S. to foreign pretax earnings the same. Then, we applied Trump’s 15% federal statutory tax to our forecasts of each company’s U.S. earnings starting in 2018, assuming it will take about one year for the tax code to change once the new administration takes office. For state and foreign taxes, we average the effective rates of each over the past three years and apply them accordingly. This assumes that there aren’t any material changes to tax rates from either source.
Capital Mobility, Tax Breaks for Net Exporters Are Hidden Benefits of Reform
If indeed market prices are factoring in some form of corporate tax reform, what remains is uncertainty about how fast it can happen. Trump’s campaign rhetoric highlighted tax reform as a top priority in the first 100 days of his administration, an outcome with good potential for fast-tracking due to the extensive work already done by House Republicans on the Blueprint for Tax Reform, one of six focus areas in the Better Way agenda currently championed by House Speaker Paul Ryan.
While the Blueprint proposes cutting the corporate tax rate to 20% instead of Trump’s 15%, three additional elements of the plan would probably benefit U.S.-based multinationals, in our view. First, like Trump’s plan, business-related capital expenditures would qualify for full and immediate deduction against pretax earnings to encourage domestic corporate investment. Second, capital mobility would be greatly improved by enacting a modest tax of 8.75% on any cash repatriated from abroad and 3.5% on any illiquid assets--rates that are lower than Trump’s originally proposed one-time tax holiday of 10%. All four companies maintain significant amounts of cash overseas, with Honeywell serving as the unusual outlier by maintaining nearly all its cash in foreign markets. Assuming all this cash is brought back to the U.S. in one lump sum under the proposed repatriation tax, each company could reinvest in several years’ worth of capital expenditures, research and development, or even mergers and acquisitions.
Third, the Blueprint calls for border adjustability of taxation, which allows any profits made on exports to be tax-exempt. In our view, this is one of the more significant aspects of the tax reform proposal, as it directly addresses the new administration’s displeasure with offshoring U.S. manufacturing; yet each company is likely to be rewarded immediately, because despite wide-reaching global operations, they all remain large exporters.
Even though globalization has suffered a lot of bad press lately, border adjustability provisions in the tax code will allow these companies to benefit from what they are already doing. At GE’s outlook meeting, CEO Jeffrey Immelt made a point to say that there is a big difference between globalization, which is illustrated by 85% of GE’s U.S.-produced gas turbines and jet engines going to international customers, and outsourcing, which is described as moving manufacturing overseas to make products more cheaply for Americans. While all four companies have increasingly embraced localization over the years to streamline manufacturing efficiencies by establishing operations near significant customers, there are still clear security, intellectual property, or human capital benefits to retaining manufacturing in the U.S. for certain critical pieces of capital equipment. That these companies still generate significant amounts of sales from exports leads us to surmise that there could be greater upside to our fair value estimates beyond the initial Trump tax scenario. Those that are significant net exporters--meaning they export more goods outside the U.S. than they import--are likely to benefit even further. GE and 3M highlighted this advantage at their recent outlook meetings, whereas United Technologies and Honeywell do not disclose their specific net export positions. While risk remains that Democrats will stall progression of this largely Republican agenda, management teams are nevertheless cheered by a strong chance for some kind of corporate tax reform in 2017.
Trump’s campaign promises included $1 trillion of infrastructure spending. The idea has ruffled the feathers of Republicans who think it is too expensive; however, Senate Minority Leader Chuck Schumer recently praised the plan, which signals some potential for bipartisan support. That said, we didn’t observe the same level of enthusiasm for this plan among the management teams at their outlook meetings that we did for tax reform. We attribute this to a lack of any appreciable benefit from the $830 million stimulus package signed by President Barack Obama in 2009. None of the management teams we asked about this directly attributed the prior stimulus spending to any boost in organic revenue growth; as such, we expect there is wide-ranging skepticism in the viability of the plan as well as the overall benefit. Nevertheless, even if the direct effects of infrastructure stimulus are modest, any improvement in organic revenue growth beyond the low-growth averages experienced by our four-company peer group of late is likely to be rewarded by the market.
New Bull-Case Scenarios Involve Both Tax Reform and Infrastructure Stimulus
We believe that the combination of tax reform and infrastructure stimulus would create significant value. As such, we chose to interact these factors in our new bull-case scenarios. In addition to the Trump tax rates we derived, we also assume that infrastructure stimulus will support top- and bottom-line expansion. Along with a reduction in corporate tax rates, only a modest multiple of our base-case organic revenue growth rates is needed to produce our bull-case fair value estimates. That said, any infrastructure stimulus is likely to be a fleeting benefit, and our bull-case scenarios assume that mid-single-digit organic revenue growth rates and peak operating margins are sustainable. Trump’s target of 4% GDP growth in the U.S. combined with mid- to high-single-digit average growth in emerging markets could support our bull-case revenue growth assumptions. However, it remains to be seen whether these policies will sustain U.S. economic expansion.
Uncertainty surrounding the magnitude and timing of changes that the Trump administration aspires to make prompts our caution in our base-case scenarios. While the new administration is likely to find support in the Republican-controlled Congress, the majority is slim, and congressional Democrats may find a way to effectively block radical changes in government policy. Furthermore, even if Trump’s plans execute perfectly, our scenarios do not test the impact of a stronger U.S. dollar, one likely outcome of a strengthening economic environment that could weaken the attractiveness of U.S. exports overseas. Until we are more certain about the viability of the new administration’s plans, we prefer to model these four wide-moat companies with assumptions that mirror historical tax and growth rates and encourage investors to wait for a pullback in shares before building positions in GE, Honeywell, and 3M. United Technologies, on the other hand, looks slightly undervalued to us, even following its postelection run. In our view, the market continues to underappreciate Pratt & Whitney’s longer-term growth potential. For this reason, we currently recommend United Technologies over the other three.
Barbara Noverini does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.