The wave of Republican victories in mid-term elections blew past everyone's expectations and sparked a rally in the markets. Investors are hoping for a range of business-friendly changes in Washington from a less intrusive energy policy to a partial repeal of some Obamacare regulations.
The market may be disappointed next year as Republicans find many areas on their wish list off limits against a Presidential veto. The President looks to be crafting his legacy on environmental and healthcare issues and will not give up easily.
Both the President and the Republicans in Congress have talked up the need for tax reform. The President has pointed out the many tax breaks incorporated in the tax code, while Republicans point out high statutory rates.
If the two sides can come together for a bipartisan deal, then it could mean hundreds of billions in tax savings for companies and a wave of special dividends for investors. That's because any reform will likely include some form of a repatriation holiday, allowing companies to bring back overseas profits without paying the full current rate.
The 2004 tax holiday allowed foreign-earned income to be repatriated at a 3.7% rate. Domestic companies brought back $362 billion with an estimated 92% going to shareholders through buybacks and special dividends.
The savings on a 2015 tax holiday could be larger by more than five-fold. As of May 2014, 307 of the largest U.S. multinationals held $1.95 trillion in accumulated profits overseas, according to Bloomberg.
A few companies desperately need a repatriation holiday. Their domestic coffers are running dry, forcing them to issue debt to fund research and return cash to shareholders. Balance sheet weakness has weighed on stock prices, but any sign of repatriation without the heavy burden of taxes could send sentiment soaring.
Strong Businesses With Weak Balance Sheets
The companies below are by no means alone in their need for a repatriation holiday -- they just need it more than most. While their strong credit ratings and size should support liquidity even without bringing back profits from overseas, a repatriation holiday would be a boon to their financial health.
Illinois Tool Works, Inc. (NYSE: ITW) reported $3.6 billion in cash as of fiscal 2013, but disclosed that, "primarily all of which was held by international subsidiaries."
The United States account for 43% of its total operations, which, roughly applied to free cash flow, means the company may have collected just $929 million. And the actual amount of U.S. cash collection is likely much lower due to higher domestic expenses.
The company paid a cash dividend of $528 million and bought back $2.1 billion in shares last year, partially-funded by more than $3.3 billion in new debt.
The Drug Dilemma
The situation is getting dire for many drug companies that may not have enough cash in the United States to fund needed R&D programs. A report by Goldman Sachs found the high rate of taxes on repatriated funds is driving tax inversion deals to shore up revenue as pipelines run dry from lack of domestic research.
Eli Lilly And Co. (NYSE: LLY) holds 89% of its cash overseas, with just $565 million available domestically. Dividends and buybacks cost the company $3.8 billion in 2013, while free cash flow across the whole company was only $4.6 billion. Sales in the United States increased 5% in 2013 to $12.9 billion, nearly 56% of total sales.
Applying the ratio of domestic sales-to-free cash flow means the company has just more than $2.56 billion to meet domestic cash costs.
While Eli Lilly has not needed to issue debt over the last several years, it has a $200 million bond due in January 2016 and may need to issue debt to cover cash needs.
Merck & Co, Inc. (NYSE: MRK) holds 85% of its cash overseas with just $3.07 billion in domestic cash. Dividends and buybacks cost the company $11.8 billion in 2013, while free cash flow across the whole company was only $10.1 billion. Sales in the United States declined 11% in 2013 to $18.2 billion, just 41% of total global sales.
Applying the ratio of domestic sales (41%) to free cash flow means the company has just more than $4 billion to meet domestic cash costs.
Merck issued nearly $6.5 billion in debt during fiscal 2013 and has $2 billion in 2015 debt maturities. Without a repatriation of profits over the next two years, the company will continue to issue large amounts of debt.
Risks To Consider: The new Republican Congress does not take power until January and even then, tax reform is notoriously slow. Do not expect any reform until late 2015 at the earliest, but any movement on the issue, or talk of a repatriation holiday, could help drive sentiment in the companies that need it most.
Action To Take --> Any movement toward a tax deal could help move shares of the companies that need it most and special dividends would surely follow a repatriation holiday. Investors should position in companies with sustainable liquidity to wait out negotiations on tax reform.
Although dividend payments and share repurchases are draining these companies' coffers, when done responsibly, they are two of the hallmarks of a profitable company. We use these two metrics -- along with debt reduction -- to comprise a company's "Total Yield." In fact, from 1982 through 2011, the top 25% of Total Yield stocks returned 15.04% per year -- smashing the S&P 500's performance. For more information, click here.