Charly Travers

Portfolio Manager

What Did Tax Reform Really Do for American Businesses?

The business world is currently focused on topics such as tariffs, potential trade wars, and the rate of future interest rate increases. While those things are important, I’m looking at what America’s CEOs are saying about the Tax Cuts and Jobs Act that President Trump signed into law on Dec. 22, 2017. There are elements of that law, including the reduction in the federal tax rate from 35% to 21% and the shift to a territorial tax system, that could have a significant impact on corporate America and how executives reinvest profits back into businesses.

Three months after the law took effect, executives from nearly all domestic companies have had the chance to communicate the impact of the law on their business through an earnings conference call with shareholders. I reviewed the earnings calls for the companies held in The Motley Fool Small-Mid Cap Growth Fund to see what CEOs and CFOs at domestic companies are saying about the impact of the new law on their business.

I was looking specifically for commentary that centered on employee hiring and compensation and capital allocation decisions. Here’s what I found.

Hiring and Employee Compensation

Companies with growing businesses are hiring to support their growth. I saw evidence of this trend across the technology, consumer discretionary, and industrials sectors, among others. These companies need more sales reps, product development engineers, and manufacturing plant employees to grow. The basis for the hiring amongst these companies is simply that business is good right now. They’re doing what it takes to meet the demand for their products or services. This was going to happen whether or not the federal tax rate was lowered.

I did not, however, see potential wage increases or cash bonuses for rank-and-file employees discussed on these calls, aside from a few specific exceptions. In those instances, there are pockets of wage inflation across manufacturers, restaurants, and transport companies. For example, companies involved in the manufacturing of recreational vehicles and their components, such as Thor Industries and LCI Industries, are dealing with tight labor markets. This situation is pushing up wages and resulting in the implementation of employee training and retention programs. Restaurants, meanwhile, are seeing labor costs rise because of higher minimum-wage requirements. While there were reports earlier this year that some Fortune 500 companies were paying companywide bonuses because of the new law, that appears to be a rare event. Among domestic small- and mid-cap names, I am seeing wages going up only when competitive dynamics or regulatory changes force a company’s hand.

Capital Allocation Decisions

A lower corporate tax rate directly increases the profits a company earns and the cash available for executives to deploy. To make a broad generalization, companies can invest in their organic growth initiatives, acquire other companies, buy back their own shares, or pay a dividend. If CEOs are planning to deviate from past strategy because of the corporate tax cut, so far they’re keeping those intentions to themselves.

For example, companies that regularly purchase smaller names already have established M&A criteria covering areas such as strategic fit and valuation. Once a decision to make a purchase is made, there are several options for financing, including equity, debt, and retained earnings sitting in the bank as cash. For deals over a certain size relative to the size of the acquirer, cash in the bank can be the least important factor in financing the transaction.

However, there is one notable exception with respect to taxation of foreign earnings and repatriation of cash held overseas. Companies with profitable overseas operations had been piling up cash held abroad. They were reluctant to bring that cash back to the U.S. because of the potentially high tax hit such a move would trigger. Now under the new law, that cash can be used in the U.S. after paying a one-time repatriation tax. Companies with large overseas cash balances may find it appealing to put that money to work domestically. Medical-device company ResMed, a leader in the sleep apnea space, was clear on its call that it was now more appealing to use foreign cash for domestic investment, including acquisitions.

With respect to share repurchases and dividends, my take is that companies are staying on their prior course with respect to their policies. Companies that regularly repurchase shares appear on track to continue doing so within the bounds of existing repurchase authorizations. The dividend-paying companies look to be raising their dividends in line with business performance. I didn’t see a single executive come out and say that there was any plan to buy back more stock or increase the dividend because of a lower tax rate.

What to Expect

The only consensus views I could find among domestic executives were that tax rates were coming down and that their teams still had a lot of work to do to sort through all the implications. I don’t see signs that there will be a marked increase in share repurchases or dividends from the tax cuts. If there is an increase in acquisition activity, it appears that it will be driven more by repatriation of overseas cash than from a lower domestic tax rate.

As of 2/28/2018, 5.27% of the Motley Fool Small-Mid Cap Growth fund was invested in Thor Industries, 4.30% was invested in LCI Industries, and 3.35% was invested in ResMed. As of 2/28/2018, 1.35% of the Motley Fool Global Opportunities Fund was invested in LCI Industries and 2.18% was invested in ResMed.

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