Companies’ financial statements show which ones have a special advantage that will boost profits
There are winners under the new tax law — and then there are the really big winners.
Any company that pays enough in taxes will save money because the corporate tax rate was cut to 21%. But the big winners are the ones that get a double shot of gains because they also have lots of deferred tax liabilities (DTLs), points out Charles Mulford, an accounting professor at Georgia Institute of Technology.
Think of a deferred tax liability as a store of value to offset higher taxes in the future. This situation typically arises when companies take deductions on big-ticket items at a faster rate for the tax books than for the regular financial statements that we see as investors.
They do this to save on taxes near-term, of course, which is perfectly legal. But then taxes go up as those deductions wear off. To bookmark the difference for investors, so to speak, companies set aside deferred tax liabilities.
Companies have to calculate the amount using the prevailing tax rate. So now that it’s 21% instead of 35%, they are slashing these set-asides. The change unleashes lots of value at companies with big DTLs. How much? Their new deferred tax liabilities are 60% of the old amounts (or 21%/35%), points out Albert Meyer, a money manager at Bastiat Capital. In other words, their deferred tax liabilities go down by 40%.
The “savings” will show up on the income statement as “earnings” and theoretically boost a company’s book value and market cap. The numbers can be huge. AT&T Inc. T, +0.99% has an enormous deferred tax liability of $64.4 billion. It can slash that by $25.8 billion, which is over 10% of its $237 billion market cap.
The biggest winners are usually companies that spend a lot of money on capital equipment — in the telecom, energy, railroad and utility sectors. To find them, I used a screen of Russell 3000 companies provided by S&P Global Market Intelligence. In this group, there are about 1,100 companies with net DTLs (deferred tax liabilities minus deferred tax assets). But many of these have small DTLs, so you can ignore them.
Next, I threw out companies that have effective tax rates of close to 21% or less. Since they already pay taxes below the new corporate tax rate, we can’t really think of them as double winners. They won’t pay lower taxes because of the tax cut. I also eliminated companies that pay a lot of foreign tax (the U.S. tax cut won’t help them as much).
Here are the biggest potential winners.
Telecom and cable companies
With their big spending to support wireless networks and internet data pipes, telecom and cable companies top the list of those with lots of DTLs. Verizon Communications Inc. VZ, +0.79% is a close second to AT&T, with $48.3 billion, for a “savings” of $19.3 billion from the tax law change, or almost 9% of its $218 billion market cap. Comcast Corp. CMCSA, +1.57% comes in third, with $35.6 billion in net DTLs. Its $14.2 billion in savings amount to about 7% of its market capitalization.
On the list after telecom companies are the energy giants. They spend a lot on equipment for production, pipelines and refineries. Here, the biggest winner by far is Exxon Mobil Corp. XOM, +0.71% It has DTLs of $34.4 billion. It can now lop 40% off that set-aside, for a “savings” of $13.8 billion. Exxon is so large, with a market cap of over $360 billion, that the benefits to investors are more limited. But the DTL reduction still amounts to almost 4% of market cap.
Chevron Corp. CVX, +0.41% looks like a potential winner with DTLs of $17.4 billion. But it pays mostly foreign tax, so the gains in changes in U.S. tax law won’t be there.
Berkshire Hathaway Inc. BRK.B, +0.97% CEO Warren Buffett loves railroads because they have a natural moat around their business. It’s hard to replicate a railroad. Plus they’re a preferred form of shipping since they beat a lot of competitors on cost. But locomotives and rolling stock are expensive. So railroads rack up the DTLs.
Union Pacific Corp. UNP, +0.47% has the most in the group, at $16.5 billion. It stands to “save” or reverse $6.6 billion in DTLs which adds up to about 6% of its $107 billion market cap.
CSX Corp. CSX, +3.15% comes next with DTLs of $9.8 billion, followed by Norfolk Southern Corp. NSC, +1.85% at $9.4 billion. They’ll each save around $4 billion, or 8%-10% of their market caps. The railroads pay fairly high tax rates of around 35%-37%, so they look like big winners on the tax-cut front as well.
With their large investments in power plants and transmission lines, utilities have a big presence on my short list of companies with lots of DTLs. There are 67 of them on my top 900 list.
Exelon Corp. EXC, +0.47% comes in first with DTLs of $19.2 billion. Other names that rank high include Southern Co. SO, -0.69% at $16.6 billion, Duke Energy Corp. DUK, -0.09% at $15.6 billion, American Electric Power Co. AEP, -1.36% at $12.6 billion, and Consolidated Edison Inc. ED, +0.02% at $10.7 billion. Utilities also stand to “save” the most from DTL reversals, ranging from 11% of market cap at Duke, to 14% for Southern and American Electric Power, and 17%-20% for Consolidated Edison and Exelon.
Utilities like these look attractive because they’re unloved. They’ve been hammered hard since November and December on worries that interest rates will increase because inflation will go up. Generally, bond-like stocks sell off as investors worry more about rising interest rates.
But utilities have been hit so hard that these fears may already be priced in. And what happens if inflation goes up less than expected because of ongoing downward pressure on prices by forces like technology, Amazon.com Inc. AMZN, +0.28% cheap imported goods and the aging of the population? (Older people earn and spend less so they drive up prices less.) In that scenario, utilities would be big winners since the current rate-hike fears would be misplaced.
No one knows for sure if these four structural forces will continue to suppress price gains, or if interest-rate-hike fears are already fully priced into utility stocks. But it’s certainly possible. And the five utility stocks mentioned above feature dividend yields of 3%-5%. That income plus the big gains from reversals on deferred tax liabilities could add up to some significant winnings for investors who buy these hated names now.