February 6, 2018
For the first time in 31 years – or since the Chicago Bears won their only Super Bowl – Congress has passed major tax reform legislation. Since the changes were signed into law in December, CFOs and their teams have been busy understanding the technical aspects of tax reform and the implication to tax expense and liabilities. While this is an important near-term priority, the significance of the Tax Reform Reconciliation Act (TRRA) is actually substantially more far reaching, as it impacts a crucial decision for almost every company: how to deploy its capital. In many cases, a CFO’s organization will need to enhance the information, process and tools to help them answer these questions.
In short, the Act has changed the game. Much lower US tax rates, full deduction of capital expenditures, a territorial tax system, caps on interest and executive compensation deductions, minimum taxes on foreign income, and changes to pass-through provisions fundamentally alter the cash flows and returns of a company’s strategy and investments. These are complex changes with many “puts” and “takes.” For example, a company might cheer the lower US statutory rate, the ability to immediately expense qualified capital expenditures and lower cost access to its foreign earnings. But it might not enjoy paying the one-time tax bill on past foreign earnings, adjusting to the cap on interest deductions and learning a whole new language to avoid such provisions as GILTI and BEAT. Thinking through the strategic implications of these changes and their impact on value will require a new set of rules for the road.
Intrinsic value (i.e. discounted free cash flows) now becomes an even more critical way for a company to evaluate its strategic investments and alternatives. Short hand metrics, such as EBITDA, that don’t account for tax and capital investments are even less accurate proxies today than they were before the Act. Cash flow has always been king and should be measured directly in this new tax world. It is more important than ever for companies to use maximizing cash flow or intrinsic value as the choice criteria for evaluating alternative uses of capital.
Early signs of tax reform’s impact
While tax reform has just recently passed, the capital market impact of tax reform has been progressively felt since Election Day. The prospect of tax reform is clearly not the only driver of market values, but it seems more than a pure coincidence that the S&P 500 was up 23% from Election Day to the date the Act was passed, and the impact on corporate earnings from moving from a 37% effective rate to a 23% effective rate is 22%. Said simply, investors have started to bake the impact of tax reform into company market values.
For example, one retailer’s share price has recently increased by $20 a share. Our analysis indicated that $16 of that increase was a result of the increased cash flows expected as a result of the tax changes, and only $4 was from a better than expected holiday shopping season. As CFOs begin to understand what they plan to do with this cash, they must first determine how much money investors expect the company to return to shareholders. How much does the company have to reinvest in its business? What are investors expecting in terms of returns for this investment?
Where tax reform will require updates
Once CFOs understand investor expectations, they should start to think through where to deploy capital to generate the highest returns. The Act changes the future cash flows and value of the company’s current investments, and management needs to revise its strategy and structure, then update or develop new and enhanced tools to help them evaluate alternative investments and maximize the return on capital. As CFOs perform this analysis, the following information, process and tools will likely need to be updated or developed:
- Capital expenditures and portfolio optimization: At the lowest level, the Act has changed the expected future cash flows or value of a capital project. The models used by clients need to be updated to reflect these changes, which will include both modifying the cash flows and the discount rate used. A company doesn’t just invest in a single project, however. They invest in a portfolio of projects, many of which are interdependent. More sophisticated portfolio optimization capabilities and tools can help businesses improve the return on investments. Even before tax reform we were seeing one company’s ROI on capital expenditures increase by more than a third as a result of using more sophisticated portfolio optimization tools. The impact going forward will likely be higher.
- Deal models: Simply put, the models used by companies are no longer accurate. Many historically used have either been unsophisticated (e.g. EBITDA multiple based) or had material errors in logic. In fact, we have found that close to 80% of deal models had material errors in logic and calculation before the Act was passed. That number will likely approach 100% as companies struggle to accurately model the impact of the Act. CFOs should conduct a very quick health check on their deal models and develop more accurate and sophisticated models that reflect the new tax law as appropriate.
- Strategic and tax forecasting: The Act requires CFOs to once and for all break down the silos between tax and business planning. Most companies have separate operations and tax forecasting that makes it difficult for companies to trade off the operating benefits of a certain strategy with the tax implications. The ability to forecast a company’s operating model’s pre-tax income by product/service, legal entity or tax jurisdiction over an extended (5 to 10 years) forecast period is more critical than ever. Without this view, CFOs will simply not be able to model out the impact of tax reform and take the actions necessary to maximize the value to the company.
- Business models: The impact of the Act, however, is not just about incremental investments; it is about future business strategy, supply chain and structure. The old world, in which earnings were placed in lower-tax foreign jurisdictions, minimizing profits in the US, is no longer valid – or at a minimum is much more nuanced. The new law will require companies to take a fresh look at how they structure supply chains and business strategies. Strategy should be the result of understanding where value is concentrated and leveraging a differentiated set of capabilities to profitably win in these markets. Yet the Act will affect where value is concentrated and potentially some strategies to extract value. We have found that across industries and markets, value is usually highly concentrated; one-third of products, customers and services generate value, one-third breaks even and one-third actually consumes value. The Act will likely affect where value is concentrated in the future. It will be important for us to team with our advisory colleagues to help them understand this shift. It will be important for CFOs to help their organizations understand this shift in value concentration and respond accordingly.
- Capital structure: At a macro level, these individual investment decisions in organic growth opportunities, deals and business model changes need to be funded. The returns on these investments need to be evaluated in the context of the company’s overall cash needs, risk and, most importantly, value impact. How much debt vs. equity should the company have? How much should the company invest in a deal vs. organic growth? How much cash should be returned to shareholders in terms of dividends and buy backs? CFOs will need to think through and evaluate these capital structure alternatives through the lens of tax reform.
Not since William Perry was doing the Super Bowl Shuffle have we had such a fundamental change in federal tax policy. The implications for where and how a company allocates capital can be profound. This will put pressure on CFOs and their organizations to enhance the information, processes and tools needed to guide capital allocation decisions.