The new US tax plan: why buybacks are getting a boost

The Tax Cuts and Jobs Act, signed into law by President Donald Trump in December 2017, has brought in major tax benefits to US corporations by reducing the corporate tax rate to 21% from 35%, introducing a one-time reduction in repatriation tax to 8 – 15.5% from 35%, and exempting US companies’ foreign income from US taxes. Consequently, US companies will be flooded with cash in the coming years.

The tax cuts were intended to spark corporate investments, create new jobs, and drive wage increases through higher cash flows. Right after the law was passed, companies rushed to announce executive bonuses and investments, but the initial excitement was soon replaced by a flurry of press releases from major companies boosting their dividends and share buybacks – Apple announced its $100 billion share buyback plan, Cisco planned to return $25 billion to shareholders, Well Fargo received approval to buy back shares up to $24.5 billion, Pepsi authorised $15 billion in stock buybacks and Broadcom unveiled a $12 billion buyback program.

So far in 2018, shareholders have emerged as the real beneficiaries of the tax cut – the first quarter of 2018 witnessed a staggering 42% YoY increase in buybacks. While we believe that the reduction in corporate tax rates alone positions 2018 as a record-setting year for buybacks, repatriation of cash significantly increases this possibility.

US Corporates’ share buybacks over the years ($ billion)

Note: Buybacks for S&P 500 companies
2018 Forecast based on Bloomberg, JP Morgan and Goldman Sachs estimates
Source:  S&P Dow Jones Indices

We think that the following four factors best explain why the tax plan is leading to such a massive increase in buybacks instead of boosting corporate investments or wage growth (i.e. the desired objectives):

• The tax savings provide more cash to already cash-rich companies : Corporate America has been hoarding cash long before the new tax law was announced. The cash pile of Non-Financial S&P 500 companies reached a record $1.7 trillion at the end of 2017 – of which the majority was held overseas. Prior to this tax law, cash-rich companies were borrowing money to buy back shares to avoid taxes while repatriating cash. The tax law has provided these companies an opportunity to repatriate cash from foreign subsidiaries and return it to their stockholders.

Cash balance of corporate America ($ billions)

• The problem was not the lack of cash but lack of investment/capital expenditure options : An analysis of the capital allocation strategies of the Non-Financial S&P 500 companies shows that the capital expenditure has remained stagnant over the last decade while share buybacks increased significantly over the same period. Capital expenditures were not restricted due to lack of cash but due to lack of investment options – as a result, the companies have returned capital to shareholders via buybacks and dividends. While there will likely be an increase in capital expenditure in the coming quarters, it will not be as large as buybacks.

  Share buybacks and capital expenditure as a percentage of cash flow from operations
  

Note: Data for Non-Financial S&P 500 Companies
Source: Capital IQ

• The interest rate environment is still conducive for companies to tap the debt market: The increased cash levels would provide greater flexibility to borrowers, especially the ones raising debt to buy back shares, and only a few of them might set aside cash to de-lever their balance sheet. Nevertheless, the possibility of large debt repayments is low as companies raised cheap debt to optimise their capital structure and it is unlikely that they will now deviate from it. Moreover, the easy access to debt markets for strategic acquisitions also means that the increased cash levels may not be fully channelled towards M&A activities.

• Smaller businesses, the ones more likely to create new investments and jobs, aren’t gaining as much from the tax cuts: Large corporations get a permanent 40% reduction in taxes, however, small businesses, which account for half of the US economy, do not get equal benefits. Small businesses, such as Corps, LLCs, sole proprietors, and partnerships are the ones that are likely to invest most of their tax savings to create jobs – such entities only get a 20% deduction on ‘qualified’ business income and that too for a limited time period (the deduction is set to expire at the end of 2025). Although there is a reduction in the individual tax rate as well, the cumulative benefits are much less for smaller businesses when compared with large corporates.

Overall, we believe that while the tax cuts will increase capital expenditure and investment in R&D and employees, buybacks will continue to grab a larger slice of the pie. The tax cuts may not have urged companies to start a buyback programme, but it is certainly making them bigger!