INSIGHT: US tax reform to boost chemical capital investment, open M&A options

26 January 2018 12:20 Source:ICIS News

NEW YORK (ICIS)--US tax reform is set to have profound implications for the US chemical sector – from overall profitability to capital investment, mergers and acquisitions (M&A), stock buybacks and debt financing.

Signed into law in December 2017, the new US tax regime brings corporate tax down from a top rate of 35%, to 21% across the board, and also allows for full expensing of certain capital investments such as machinery and equipment for the first five years.

“There is no question the tax reform act will benefit US headquartered chemical companies because the lower tax rate will directly increase after-tax profits. Each company will decide where they will use the extra earnings, whether it is greater dividends, stock repurchases, increases in wages, increased investment in their business, or more acquisitions,” said Peter Young, president of investment bank Young & Partners.

In addition to the increase in profitability that comes with a lower tax rate, particularly for companies with a higher percentage of US sales, there are more specific implications.

INVESTMENT BOOST
The ability for companies to expense 100% of certain capital expenditures (CAPEX) such as plant and equipment for the first five years (being phased down in the following five years) should spur quick investment decisions on major chemical projects in the US.

The US is now not only feedstock advantaged with shale gas, but also tax advantaged (or at least less tax disadvantaged). There’s a compelling argument for investing in major projects today – a lower tax rate on profits generated from those assets, and the five-year window of full deductibility of CAPEX.

As chemical companies evaluate the second wave of new cracker and derivative investments, along with other major projects, expect more to get the green light.

Companies still on the fence about propane dehydrogenation (PDH), polypropylene (PP) and methanol projects, should feel a powerful wind blowing in the direction of action.

Capital intensive commodity chemical companies are likely to focus more on internal rate of return (IRR) and after-tax return on assets (ROA) – “a recipe for tolerating lower margins across the next cycle, and consequently taking on more projects”, noted Laurence Alexander, chemicals equity analyst at Jefferies.

The full expensing of certain CAPEX carries into M&A.

“This also means that if you structure deals as asset sales, some or all of the non-goodwill portion of the purchase price can be deducted in the first year, providing real value to any buyer,” said Alex Khutorsky, partner at investment bank The Valence Group.

Goodwill is the difference between the purchase price of a company, and the fair market value of its tangible net assets.

This deductibility could be one factor putting upward pressure on M&A multiples, as buyers would be able to pay more, said Khutorsky.

“The 100% expensing of CAPEX will be very stimulative, with benefits in particular for investment and asset purchases,” said Leland Harrs, managing director and head of chemicals at investment bank Houlihan Lokey.

“The tax reform is supportive of a strong M&A market, but you don’t need M&A to benefit,” he added.

The overall US tax reform also makes US assets more attractive to foreign buyers with “an economic incentive to buy US assets that wasn’t there before,” said Harrs.

“It’s a tailwind, but we don’t see a wholesale rush to buy US assets,” he added.

REPATRIATION IMPACT
With attractive terms for repatriation of cash, US chemical companies should have a lot more funds available to make capital investments, as well as acquisitions and stock buybacks.

The new “deemed repatriation” tax provision makes all profits of US companies generated (and mostly thus held) overseas “deemed” to have been returned to the US and taxed one time at a 15.5% rate for cash and 8% for reinvested assets.

Companies that bring back cash to the US must pay tax immediately, while those that leave cash and reinvested assets abroad can pay the tax over an eight-year period.

Importantly, future foreign profits would not be taxed in the US beyond what they are already taxed abroad, giving zero incentive to keep excess cash outside the US from a tax standpoint. Any future profit generated outside the US can be now be repatriated at any time at no cost.

With the huge flow of cash coming back to the US, or at least available to bring back with no penalty, the range of options for companies opens up considerably.

For example, a US company that would have wanted to make a large acquisition in the US, but was hindered by having a good portion of its cash held overseas because of a potential tax penalty, could now fund that deal if it so chooses.

The combination of US companies having lower overall corporate taxes, and the fact that they no longer have to pay US taxes on foreign profit “allows US companies to be much more competitive in the international M&A market”, noted The Valence Group’s Khutorsky.

US CORPORATE DEBT IMPACT
However, as mentioned in a previous article, companies must think twice before levering up with acquisitions or massive share buybacks, as an important provision in the new US tax law caps the deduction of interest expense at 30% of earnings before interest, tax, depreciation and amortisation (EBITDA) through 2021.

Thereafter, interest expense deduction will be capped at 30% of EBIT – a huge difference, especially for the capital intensive chemical sector where D&A tends to be significant.

Previously, 100% of interest expense was deductible.

“At least through 2021, we don’t actually see this having a material impact on leveragability so long as interest rates remain low,” said Khutorsky.

“However, it increases risk in leveraged companies that are cyclical, especially as the cycle turns and EBITDA falls away,” he added.

Companies with high debt levels can be penalised by this tax change, and the impact magnifies as EBITDA (and EBIT) shrinks during a downturn. Those struggling with high debt levels will be even more disadvantaged if earnings decline sharply in the next cyclical downturn.

MACROECONOMIC TAILWINDS
However, the net impact of the tax reform is likely to be positive for the US economy, especially in the next few years.

The IMF just raised its global GDP growth forecasts for 2018 and 2019 by 0.2 percentage points for each year, to 3.9%, for each year. Half of that cumulative revision was based on the impact of the US tax package.

“The US tax policy changes are expected to stimulate activity, with the short-term impact in the United States mostly driven by the investment response to the corporate income tax cuts,” according to the IMF.

The IMF raised its US GDP growth forecast for 2018 from 2.3%, to 2.7%, and for 2019 from 1.9%, to 2.5%.

“The effect on US growth is estimated to be positive through 2020, cumulating to 1.2% through that year, with a range of uncertainty around this central scenario,” it added.

The IMF also noted that because of the temporary nature of some of the US tax provisions, it is projected to lower growth “for a few years from 2022 onwards”.

For US chemical company earnings, Wall Street analysts have made initial steps in revising estimates higher, but note that more changes are likely to come after Q4 earnings conference calls, when more information on the impact of US tax reform are divulged.

By Joseph Chang

By Joseph Chang