U.S. corporations are currently taxed at a statutory rate of 35%, the highest among the Organization for Economic Co-operation and Development nations and one of the highest in the world. In addition, U.S. corporations face taxation at the state and local level at an average of approximately 4.1%. Moreover, the United States is the only country that has adopted a worldwide system of taxation. As such, U.S. corporations face the prospect of being taxed not only on their earnings related to U.S. domestic operations, but also for activity related to their subsidiaries overseas (less applicable credits for taxes paid to foreign nations). However, U.S. corporations can indefinitely defer taxes on their overseas earnings unless cash is repatriated to the U.S.
Republicans enjoy control of both chambers of Congress as well as the White House. However, this does not necessarily translate into legislative consensus on taxation. Both President Donald Trump and Congress want tax reform, but each side has formulated its own plans for how best to approach it. Compounding this is the lack of a filibuster-proof Republican supermajority in the Senate. As a result, Republicans have indicated their willingness to push forth comprehensive tax reform through the budget reconciliation process. Because of certain nuances to this procedure, any tax reforms ultimately agreed to would have to conform with certain spending and revenue targets, as well as other budget rules and laws.
Trump and the GOP agree that U.S. corporate tax rates should be cut, as did former President Barack Obama and certain Democrats. The main impetuses for a cut include improving U.S. competitiveness and curtailing the threat of tax inversions. Where all parties differ, however, is the extent to which rates should be slashed. Trump is in favor of reducing the corporate tax rate to 15%, whereas the House GOP has proposed a reduction to 20%. In our sensitivity analysis, we run three tax rate scenarios: 15%, 20%, and 25%. The first two scenarios reflect the Trump and House GOP plans. The 25% rate scenario reflects an outcome where the proposed rate cut is curtailed by the need to hit revenue targets or to gain buy-in from Democrats.
Regarding the tax treatment of capital expenditures, the House Republican proposal would change the current norm by allowing for the cost of capital investment to be fully and immediately deductible, obviating the need for depreciation schedules for tax purposes. It would also eliminate interest deduction. Under Trump’s plan, manufacturing firms would be given an option between full expensing of capital expenditures and deducting interest expense. Eliminating interest expense deductions is a necessary byproduct of any proposal to permit full expensing of capital asset purchases. Otherwise, a tax arbitrage situation would occur whereby companies would doubly benefit from better-than-consumption tax treatment.
Is unclear how these rules would be applied to the financial sector. The House GOP plan says its Way and Means Committee will develop special rules regarding interest expense in the business models of financial service firms. Their business models make it difficult to separate debt from reinvestment, as debt is more akin to a raw material than a source of capital. Even interest expense from corporate debt versus customer deposits, for example, would be difficult to distinguish.
Additional proposals would allow repatriation of U.S. corporate cash held overseas. The similarities between the two camps' proposals appear to end there, however. Trump would allow a one-time repatriation of currently deferred foreign profits at a rate of 10%. While the president has not yet specified, presumably this would revert to a normalized corporate tax rate. The House GOP plan, in contrast, would impose a deemed repatriation of currently deferred foreign profits on cash and cash equivalents at a rate of 8.75% and 3.5% on other profits.
Perhaps the most pronounced differences between the plans pertain to the U.S. worldwide system of taxation. The House GOP plan would create a fully territorial tax system, exempting 100% of dividends derived from foreign subsidiaries from U.S. taxation. Trump’s tax plan originally would have ended deferral. Recent iterations have appeared to walk back this proposal as the president has added more conservative tax advisors to his team. Either way, assuming Trump’s preferred rate is implemented, it would appear the distinction between a worldwide or territorial system would matter little. Ireland would be the only OECD country with a lower tax rate, and there are only so many Irish companies a U.S. corporation could conceivably acquire.
Another difference is the House GOP’s proposal to institute a border-adjustable tax. Trade was an area of focus during the presidential campaign, and the House GOP plan is meant to address the growing trade imbalance with other nations through the federal tax code. Under this plan, all business income tax would be border-adjustable, disallowing the deduction for purchases from nonresidents and exempting export profits and foreign-derived profits from taxation. In other words, the corporate tax code would solely levy tax on business transactions from the sale of goods and services within the borders of the U.S. It remains to be seen whether this would be acceptable under current World Trade Organization rules, as some believe that the House GOP measure is akin to a hidden tariff. Trump has criticized the plan as too complicated and alluded to his preference for levying overt tariffs on imports. A number of prominent Republican senators have also recently expressed their displeasure with the proposal.
Tax Reform Mostly Good News for Banks, but Impact Will Vary
We see banks with a wide or narrow moat rating, limited international exposure, limited use of tax-advantaged investments and other tax shields, and limited exposure to corporate lending as the biggest beneficiaries of reductions in tax rates
Among large banks, the sizable consumer banking businesses at Bank of America
, JPMorgan Chase
, and Wells Fargo
provide some protection in the event that reductions in interest deductions reduce the demand for corporate loans in the overall economy. Wells Fargo’s U.S.-focused business, relatively small investment banking business, and wide moat rating should allow it to make the most of lower domestic tax rates relative to its more global-oriented peers. On the other side of the coin, Citigroup
’s international footprint limits the benefits of a lower U.S. tax rate to a smaller percentage of its income. Furthermore, Citigroup maintains about $47 billion in deferred tax assets. At year-end, $23 billion of these were related to timing differences. In a scenario in which the tax rate falls to 15%, the company would probably write down its deferred tax assets by as much as $13 billion--more in the event that the U.S. moves to a territorial system.
Among regional banks, we think Comerica
, and Regions Financial
are likely to have the highest tax flow-through rates and therefore the biggest increases to our fair value estimates. Cullen/Frost
is on the other side of the spectrum, as we believe it will have the lowest flow-through among our regionals. One major factor is the bank’s outsize municipal holdings.
With only 22% of its loan book in consumer loans, Zions Bancorp
will realize less benefit than peers. While we like that management has been opportunistic with its loan and securities portfolio, Zions has loaded up on tax-free municipal bonds in the past year. In the past year, the company expanded its municipal portfolio to $778 million from $419 million. In addition, the bulk of Zions’ loan book is composed of commercial and industrial loans. Any tax breaks will mostly lead to lower interest rates for Zions’ borrowers.
Among the country’s largest banks, Wells Fargo stands out from a valuation standpoint. The company currently trades at a discount to our fair value estimate and is well positioned to benefit from potential changes in the tax regime. Wells Fargo has been troubled by the late 2016 scandal regarding its sales practices, contributing to its recent stock underperformance. On this front, too, Wells could see relief from a change in the regulatory environment. Though financial repercussions have been limited to date, a decline in regulatory attention would help the firm repair its brand in the eyes of its customers.
Most regional names we cover are currently trading above our fair value estimates, and we believe this is largely due to the market already pricing in a very good chance of a tax cut. However, if a cut to 15% were to go through, we believe there would be at least 10% or more upside to BB&T, Fifth Third Bancorp
, Zions, and Capital One
. We view Capital One as the most undervalued name not among the big four and Fifth Third as the second most undervalued if the tax rate were to be cut to 15%. We don’t see much upside to KeyCorp
, Regions, Comerica, PNC Financial
, or Cullen/Frost, even under a tax cut scenario.
Significant Spread of Outcomes for Insurers, and Potentially Some Losers
With only about 10% of the global market, the U.S. is a relatively small player in property and casualty reinsurance, a situation we largely attribute to a relative tax disadvantage, particularly in relation to Bermuda. The Bermudan reinsurance market in P&C insurance lines is actually 50% larger than the market in the rest of the Americas, a share that is dramatically out of line with the island's economic importance. Significantly lowering the U.S. tax rate could help to level this playing field and push some reinsurance underwriting back into the U.S., allowing domestically domiciled reinsurers to gain share.
Within our coverage, we see Berkshire Hathaway
's / reinsurance operations as the largest beneficiary, with W.R. Berkley
also potentially seeing a modest benefit, as reinsurance represents 10% of its premiums. We think Markel
would see a mixed but overall negative result, as its reinsurance operations (accounting for 21% of premiums) are spread across both the U.S. and Bermuda. Chubb
also has some Bermudan reinsurance operations, but we believe they are too small to meaningfully affect the overall company.
Within our domestic insurance coverage, we see a relatively wide spread of outcomes from lower tax rates. Franchises fully centered on the U.S., such as Progressive
, should see significant immediate benefits. Given that it has potentially the strongest moat in the industry, we would expect Progressive to hold these gains for a longer period and therefore see it as the biggest beneficiary from a lower tax rate. Berkshire subsidiary Geico should see a similar benefit. We would also point to W.R. Berkley as a prime beneficiary, as almost 80% of its premiums are generated by its domestic primary segment and, as mentioned earlier, it could see some benefits in its reinsurance business. Additionally, its narrow moat should help it to hold these gains.
Chubb, with 40% of its premiums generated outside the U.S. and its Swiss domicile, would see relatively little benefit. American International Group
's international footprint would also lower its gain from lower taxes, and its lack of a moat would further contribute. A bigger factor for AIG would be its substantial deferred tax assets.
For investors looking to exploit tax reform specifically, we think Travelers
offers the best potential. The stock is roughly fairly valued under existing tax rules, in our view, and the company has relatively high upside because of its domestic focus (93% of premiums are generated in the U.S.) and narrow moat.
Tax Reform Would Be Timely for Asset Managers
The traditional U.S. asset management industry is facing a multiyear period of fee and margin compression, as their primary retail distribution channels—broker/dealers and advisors--are focused more than ever on investment performance and fees and are already culling platforms to eliminate poorer-performing and more costly actively managed funds. Given this, a reduction in the statutory U.S. federal income tax rate can't come soon enough, as it will help to offset the impact of these pressures, ensuring that cash flows don't fall off too precipitously. Still, while these firms tend to be asset-light and are not balance-sheet-driven like the banks and insurers, they will carry debt from time to time. As such, not being able to deduct interest expense could prove problematic for firms carrying somewhat higher debt balances.
Within our coverage of the U.S.-based asset managers, we see a fairly wide band of potential outcomes from corporate tax reform, with firms generating a greater percentage of their pretax income domestically tending to benefit more from a reduction in the corporate tax rate.
Wide-moat companies that generate a larger percentage of their profits in the U.S., like Eaton Vance
and T. Rowe Price
, will see a much larger benefit from corporate tax reform. They are also more likely to hold on to those gains for longer periods than some of the narrow-moat firms that we expect to see meaningful increases in their valuations from a reduction in the statutory U.S. federal income tax rate, like Federated Investors
and Cohen & Steers
. On the lower end of the scale, we see firms that already pay less in taxes because they do more business overseas, like Invesco
or Franklin Resources
, or because they have meaningful amounts of deferred tax assets, like Legg Mason
While a handful of the U.S.-based asset managers--Eaton Vance, T. Rowe Price, BlackRock
, Affiliated Managers Group
, and Franklin Resources--would benefit from a tax repatriation holiday, Franklin Resources would be the biggest beneficiary. At the end of fiscal 2016, Franklin Resources had $8.3 billion in cash and another $2.4 billion in investments on its books. About two thirds of the cash and investments was held overseas, which precluded it from being used for share repurchases, dividends, or investments in the U.S.--unless the firm were to repatriate it (taking a tax hit in the process). A tax repatriation holiday would, by our estimates, allow Franklin Resources to bring $3 billion-$4 billion back to the U.S. at a meaningfully lower tax rate, with the proceeds probably going toward a special dividend and/or share repurchases.
We don't see any dramatic opportunities, but on the basis of its wide moat, domestically focused operation, and current valuation, we think T. Rowe Price looks like the best target for investors looking to exploit tax reform. The stock is modestly undervalued based on current tax rates and has significant upside.
Tax Reform Could Prompt Structural Change for Alternative-Asset Managers
Criticism of tax rules on carried interest has come from both parties, and reform has long been a divisive issue in alternative-asset management. Trump has made it clear that he plans to raise carried interest tax rates to closer to corporate tax rates.
Carried interest generated by alternative-asset managers, primarily via private equity investments, is currently taxed at 23.8% (20% tax on net capital gains plus a 3.8% investment tax for high-income earners), whereas management fees and other are taxed at higher regular corporate tax rates closer to the 39.6% top tax rate on earned income. Under the new administration, we believe the most likely reforms are that the carried interest tax rate will increase to 33% from 23.8%, whereas corporate tax rates (meaning tax rates on management fees) will decline to the low 20s on average.
Given these changes, we believe the publicly traded alternative-asset managers will seek to shift to a more attractive corporate tax structure. We acknowledge that this shift will mean that earnings will be subject to double taxation, versus being passed through to the unitholder. However, at a corporate level, we see three major benefits: retaining similar (if not more) earnings for reinvestment in the business, multiple expansion, and index inclusion. We think multiple expansion will also be aided by the fact that investors seem to prize the stability of management fee income more so than incentive income and have awarded it a higher multiple, and tax rates for management fees should decline as they will be subject to the new lower corporate tax rate.
Our fair value estimates for the alternative-asset managers have long included a long-term tax rate of 35%, recognizing that the current carried interest tax situation was untenable over the long term, even if there were no immediate threats on the horizon. We understood that investors would probably demand a discount to account for the threat. As a result, changing our tax rates for the industry doesn’t necessarily result in a material shift in our fair value estimates, as we believe the more influential factors for investors will be more technical, such as the broadening of the investor base, the potential for index ownership, and increased earnings growth via higher reinvestment in the business, among other items.
Our top ideas are wide-moat Blackstone
and narrow-moat KKR
because of the higher potential for index and broader shareholder ownership. We consider Blackstone considerably undervalued based on its current partnership structure, whereas KKR, with its progressive dividend policy paying out roughly 30% of distributable income, is already passing up the advantages of the pass-through limited partner structure for a model closer to a corporate one, where distributions would be around 25% of earnings.
We believe the shift will have a minimal financial impact on results for the industry, but the upside could be significant, as we think industry multiples could rerate closer to traditional asset managers in the 15- 17 times earnings range, from around 8-10 times now, given many institutional investors' reluctance to invest in master limited partnerships owing to tax complexity, liquidity, or mandated restrictions on MLPs. Index inclusion for some of the largest names in the industry, such as Blackstone or KKR, would be an added boost in visibility. In addition, simply having clarity on the carried interest tax issue--which has been around for a decade and is meaningful, as carried interest can generate more than 50% of a manager’s income--will help remove investor concerns. Other multiple-enhancing benefits include a large opportunity for the firms to reinvest more of their capital in businesses that generate 20%-plus returns on equity, by our estimates, and the opportunity to take advantage of lower tax rates on management fee income, which investors have consistently prized and valued the most highly, in our view. This shift would probably value firms more highly under a sum-of-the-parts model, which sell-side analysts often use to value the industry.
Smaller Investment Banks, Brokerages Would Be Biggest Tax Cut Winners
While all of the investment bank and brokerage stocks that we cover would benefit from a straight corporate income tax cut, the ones that would most benefit are the smaller, domestically focused firms. Small- and mid-cap investment bank and brokerage stocks with 15% or more upside in a 20% U.S. tax rate scenario include Evercore Partners
, Raymond James Financial
, and Stifel Financial
. Among these, Evercore Partners and Greenhill are financial-advisory-focused investment banks. Our general view is that 2017 merger and acquisition activity may stall, as Brexit, U.S. policy changes, and other uncertainties delay deals closing. That said, we believe that the pent-up demand from 2017 could be released in 2018 after environmental uncertainties are resolved.
Additionally, there’s the potential that tax law changes, such as the lower tax rate on repatriated cash, could spur acquisition activity. Raymond James and Stifel Financial would benefit from tax law changes; however, the status of the Department of Labor’s fiduciary rule is an additional regulation that investors should monitor.
and TD Ameritrade
are notable among the stocks with 15%-plus upside, as they have market capitalizations in the tens of billions but earn their income primarily from the U.S. This compares with Goldman Sachs
and Morgan Stanley
, which are large-cap stocks but are globally diversified and benefit less from U.S. tax reform. We also assess Charles Schwab and TD Ameritrade as having strong business models, exemplified by their respective wide and narrow moat ratings, and we believe that they will be able to hold on to the benefits from tax reforms for longer than no-moat firms. Additionally, Charles Schwab’s and TD Ameritrade’s earnings are highly leveraged to rising interest rates.
While Greenhill’s and Lazard
’s valuations aren’t that sensitive to U.S. interest rates, the firms may take some corporate actions if U.S. tax rates are lowered. Greenhill has said it would look to repatriate cash from abroad. In fact, the company partially carries debt to manage cash flows so that it doesn’t have to repatriate cash. Following cash repatriation, the company could take any number of corporate actions, such as retiring debt, repurchasing shares, or more aggressively expanding its business.
Changes in tax laws could spur Lazard to change its corporate structure. Lazard is a publicly traded partnership, which keeps some investors at bay as they don’t want to deal with the tax complications associated with a Schedule K-1 tax form. We know that management has considered the idea of becoming a C-corporation; a lowering of the U.S. corporate tax rate and changes to how foreign income is taxed could tip the balance in favor of changing into a C-corp.
Changes in U.S. tax policy are likely to have the least effect on Goldman Sachs and Morgan Stanley. From a pure U.S. corporate tax rate perspective, they’re relatively global companies, with about 60% and 70%, respectively, of their revenue coming from the Americas. They might see uplift in financial advisory from companies making acquisitions after repatriating of cash or increased equity capital raising if the interest expense deduction on corporate debt is eliminated. That said, investment banking revenue is only about 20% of net revenue at Goldman Sachs and 15% at Morgan Stanley, so there would have to be a significant increase in investment banking to move the needle for the entire company.
Stephen Ellis, Jim Sinegal, Greggory Warren, CFA, Michael Wong, CFA, CPA, and Joshua Aguilar contributed to this article.