$250 Billion Is Coming ‘Home’! But There’s A Catch If You’re Hoping For A Buyback Bonanza

Ok, so here we are nearly nine months on from Trump’s original “something phenomenal is coming on taxes” promise made seemingly out of the blue at a February 9 meeting with airline executives, and we still don’t know precisely what this “phenomenal” thing actually is let alone when it will be realized.

Lots of information about what’s set to be unveiled on Wednesday has been leaked ahead of time, with the latest information coming from WSJ which about an hour ago reported that the plan “will open the door to a top individual tax rate that is higher than the 35% that has been in previous plans.”

That’s apparently an effort to help Trump deflect criticism about tax cuts for the wealthy, but as the Journal goes on to note, “it also could spark an intra-Republican debate over how to tax the highest earners.”

The plan is widely expected to collapse the current seven individual tax brackets into three – or maybe four if the bit about a possible bracket above 35% is to be believed.

That comes hours after Axios revealed that “top White House and GOP leaders have agreed to raise the lowest individual tax rate from 10 to 12 percent, paired with doubling the standard deduction.”

Whatever, right? Who knows what this thing will look like once it finally becomes law and that’s assuming it ever does.

For investors, a key question is corporate cash repatriation.  The presumption here is that repatriated cash would be used for buybacks, which could come at just the right time as the window seems to be closing for the type of debt-funded repurchases that have helped levitate stocks in an era where central banks have engineered a hunt for yield among investors thereby creating an insatiable appetite for new corporate supply.

On Tuesday, Goldman is out with a new piece that takes a look at what you can expect in the event tax reform/cuts are adopted and include a one-time tax on untaxed foreign profits. Here’s Goldman:

At recent political rallies, President Trump continued to show support for reducing the tax rate on overseas earnings of US companies. White House officials also confirmed that a tax reform plan would likely include a reduced repatriation tax. The proposal has remained popular because it will likely boost tax revenues and help address the issue of revenue-neutrality in any potential tax reform package.

So just how much of the of the $920 billion in untaxed overseas cash held by S&P 500 corporates would come back? Well, around $250 billion, Goldman figures. To wit:

Based on the House Republican proposal, the total S&P 500 overseas cash balance after the repatriation tax should equal around 4% of equity cap or $790 billion. S&P 500 companies account for $2.5 trillion out of the total $2.9 trillion earnings reinvested overseas for all US businesses, including $920 billion of untaxed overseas cash. S&P 500 firms would be taxed 8.75% on their $920 billion of overseas cash and 3.5% on the remaining $1.6 trillion of overseas earnings, resulting in a total tax bill of $135 billion. Assuming firms fund the tax bill from overseas cash balances, remaining overseas cash available to S&P 500 firms would total $790 billion. However, taxes could be lower (and cash balances higher) for several US firms that have available foreign tax credits. In addition, companies may seek other methods to reduce the overall tax bill before tax legislation is passed. We estimate S&P 500 firms would repatriate $250 billion of their total untaxed overseas cash in 2018 (Exhibit 3).

US firms repatriated 25% of their total estimated overseas earnings during the 6-month period following the enactment of the Homeland Investment Act (HIA) of 2004. We expect a similar magnitude of repatriation compared with the prior tax holiday. Despite a reduced repatriation tax, companies would likely continue to spend a large share of their overseas cash to fund and expand their international operations. We estimate $540 billion of untaxed overseas cash would remain at foreign subsidiaries by year-end 2018.

So the good news for investors is that some of that $250 billion would be spent on returning cash to shareholders.

The “bad” news is, companies will be less inclined to buyback shares with the money they bring home because… well… because their shares are in bubble territory. Here’s Goldman one more time:

Despite the popularity of buybacks during the 2004 tax holiday, extreme valuations suggest firms would now be more reluctant to spend most of their repatriated cash on buybacks. Following adoption of the Homeland Investment Act of 2004, one study estimated that between $0.60 and $0.92 of every $1 repatriated was spent on share purchases. S&P 500 buyback executions rose by 84% in 2004 and 58% in 2005. However, equity valuations are much higher now than when the prior tax holiday was enacted. The median S&P 500 stock is trading at the 99th percentile of historical valuation across a range of metrics (Exhibit 6).

In addition, the S&P 500 forward P/E averaged 16x in 2004 vs. 18x during the last 12 months. Furthermore, given that firms can choose when to repatriate their post-tax overseas cash, companies can be more strategic in their use of this excess cash compared with the prior tax holiday when firms had to repatriate funds within a short timeframe.

So again, you’ll likely get some buybacks, but ironically, the fact that previous buybacks have helped drive valuations into the stratosphere means management may be less inclined to splurge on their own overvalued equity.

Of course if you’re like us, you think there are worse things that companies could be doing than considering whether spending on capex and R&D might be better in the long-run for shareholders than plowing money into stocks that are the most expensive they’ve been in history.