Glittering gifts for Investment Grade telecom companies, but only lumps of coal for High Yield
On 22nd December last year, President Trump enacted probably the most significant achievement to date of his presidency by signing the Tax Cuts & Jobs Act of 2017. The precise implications of tax law changes can be fiendishly complicated and difficult to assess due to the numbing complexity of the legislation and individual companies’ tax planning arrangements. However, in broad strokes, I believe that US businesses will benefit from a significantly lower tax burden on their domestic earnings and an even larger reduction in tax levied on the repatriation of any of the estimated $3 trillion of overseas profits that are currently held offshore by US corporates.
On repatriation of foreign earnings, the big winners are the highly cash generative international tech and pharmaceutical players who will now only suffer a 15.5% charge vs 35% previously. As an example, Apple alone has $252bn of gross cash and securities held overseas whilst Johnson & Johnson holds $41bn outside the US. However, my focus in this article is the impact the tax changes will have on the ongoing earnings and cash flow of the largely domestic-focused US telco and cable industry.
The main drivers for the reduction in the domestic tax burden will be a cut in the corporate tax rate from 35% to 21% on a permanent basis combined with an increase in the tax deductibility of upfront tangible asset investment (so called “bonus depreciation”) from 50% of the total cost to 100% until 2022 with a 20% per annum tapering off thereafter until 2027. Offsetting this will be restrictions on the deductibility of interest against tax (only 30% of taxable income) and offsetting accumulated operating losses (80% in perpetuity vs previous 100% with a 20-year limit), but I see these as far outweighed by the former cuts.
The biggest winners under this new framework will be the larger investment grade telecom and cable operators that currently pay tax at or near the full 35% rate and make significant annual capital investments in telecom and cable infrastructure. Specifically, we see Verizon, AT&T and Comcast as the big winners based on their respective YE16 corporate tax burdens ($6bn, $4bn and $4bn respectively) which were forecast to rise further from 2017 on a combination of profit growth and/or acquisitions. Estimates of the positive cash flow effect of the reduced tax burden range between $3-5bn for these names and although I expect a significant proportion to be allocated to shareholder returns, I also gain significant comfort from the material increase in ongoing underlying free cash flow that can be directed to accelerate debt reduction if required.
So are there any losers in the telecom and cable universe from these changes? Not really. There is limited upside from the reduced tax rate due to the more indebted high yield operators already paying little or no tax. However, there is also limited downside risk to high yield operators’ debt tax shields due to a combination of cash interest burdens being at or below the 30% of taxable income threshold or, in the case of those that might exceed this threshold (most notably Frontier and Altice’s Optimum and Suddenlink credit silos), the existence of significant accumulated net operating losses that are now indefinite vs the previous 20-year limit. I therefore see virtually no impact on the free cash flow (FCF) of leveraged high yield telco and cable operators.
All in all, I therefore have a positive view of the Trump tax reforms with the large operators on the cusp of a material increase in FCF and the more indebted leveraged operators at little risk of losing their existing interest and operating loss tax shields. So it really will be a Happy New Tax Year for US telecom and media companies thanks to Santa Trump’s Christmas gift.