Morgan Stanley analyzed 400+ earnings transcripts to learn how companies will spend their tax savings. Are consensus expectations for earnings too high?
While most U.S. companies stand to benefit from the sweeping tax changes implemented early this year, markets may be overlooking a critical distinction: the different manner in which businesses will spend that windfall.
Investors should focus not just on what companies stand to save from tax reform but how they plan to use that windfall.
Since mid-December, 2018 earnings expectations on the S&P 500 have risen about 7.8%, with most of that increase being attributed to tax reform. This growth, however, is predicated on most tax savings flowing through to earnings.
“Essentially, the market is giving full credit for tax benefit pass-through in consensus numbers, but based on a thorough review of company guidance, we think this may be inappropriate," says Todd Castagno, Accounting & Tax Policy Analyst for Morgan Stanley Research.
Many companies are likely to earmark some of that savings for capital expenditures, debt repayment and share buybacks. “Once we have more guidance, estimates may need to be revised down," he says.
Implied Change in Earnings: Guidance vs. Baseline
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Although companies have been quick to talk about the benefits of tax reform—most expect their tax rates to drop by 6 to 7 percentage points—many have been opaque about how they intend to use those savings.
To gain more clarity into spending intentions, Morgan Stanley Research analyzed transcripts from more than 400 recent earnings calls for S&P 500 companies to understand which companies are likely to reinvest, return capital, or do both.
% Noting Tax Benefit Uses
Based on Morgan Stanley's analysis of transcripts, approximately 44% of companies have indicated that they plan to put a portion of their tax savings into capital expenditures, higher wages and other investments for growth.
“Money being reinvested into a business is, by definition, not immediately accreting to shareholders, which we think may be a problem given high consensus earnings growth expectations," says Castagno, adding that the companies most at risk, based on elevated expectations and likelihood of reinvestment, are those in Consumer Staples, Financials, Health Care, and Industrials.
About 28% of companies mentioned plans to increase distributions to shareholders, with the topic most addressed in the Discretionary, Financial, Industrials, Staples, Tech, and Telco sectors. “Buybacks would be earnings accretive, and so a positive for equities; but we do not expect this to be a material driver of earnings growth or quality of earnings," says equity strategist Adam Virgadamo.
Sectors Noting Increased Capital Return
To a lesser degree, companies in the Materials, Consumer Staples, Telco and Utilities sectors have talked about using their savings to pay down debt. Deleveraging would be a clear positive for corporate credit quality, says Michael Zezas, fixed-income strategist. “It could help push out a turn in the cycle, or at the least, mitigate the fundamental challenges when the cycle does turn."
To be sure, the timing of these tax cuts could result in the unintended consequence of shortening the current business cycle. “An increase in business investment that coincides with rising deficits may push the economy into the last stages of the cycle earlier than would otherwise have been the case," Zezas says. That could have negative implications not just for companies with great tax-saving expectations, but also for investors across the board.
“The bottom line is that we think the market may still be a bit ahead of itself on earnings growth over the next year," says Virgadamo, noting that tax-related growth should not get the same treatment as organic growth when estimating earnings. “The recent correction gives some downside protection on valuation, but if we are right, valuations may not have reset quite as much as a Bloomberg screen would tell you."