Value Investing

Valuation Variable Equality

Several weeks ago I received an interesting email from my friend and fellow absolute return investor Frank Martin related to the new tax law.

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Valuation Variable Equality
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Frank’s email: “According to pundits the impact on S&P 500 EPS estimated to be $10, taking 2018 to $151, a forward PE of 17.4. Given where we are in the cycle, one could easily conclude that the tax cuts are more than priced in. What is a bit of a surprise to me is that nobody seems to be talking about companies involved in hot competitive rivalries using the windfall to cut prices and yet maintain margins or thereabouts. With every new technological innovation it is the consumer, and not the companies themselves, who are the biggest beneficiaries. Might not the same thing be said about the proposed corporate tax cuts?”

My response: “I agree. Higher margins from tax cuts don’t live in a vacuum. Suppliers, customers, employees, and other stakeholders will all want a cut. But I don’t have any special insight on the timing of margin reversion or who gets largest share. My view on tax cuts funded by deficits/debt, not spending cuts, is geez…at this stage of the cycle?!?!?! 2yr USTN keeps rising…1.81% today. I like it! I continue to be fascinated by the growing correlation between the short-end of the curve and asset inflation. Tax plan/more stimulus could amplify.

I was reminded of our email exchange last week while reading Cintas’s (CTAS)  quarterly conference call. On the call an analyst asked, “This has always been a competitive industry, you’ve acknowledged that regularly. What is the risk that some of the tax reform savings that the industry will earn gets competed away, think about an after-tax return as their margin or whatever is their focus? Is that — do you see that as a risk?”

Management responded, “I think it’s too early to tell. Certainly, that could throw a little bit of a wrinkle into the way our products and services are priced in the marketplace. We’re going to have to keep our eyes on that and see how it plays out. But I think it’s a little early, but certainly we’re going to keep our eyes on it.”

Cintas’s answer isn’t surprising. In fact, I expect “it’s too early to tell” will be a popular answer to questions related to the new tax law. Considering Cintas was one of the first companies to report since the law was passed, their call was filled with questions and answers related to its potential impact. I’m expecting Q4 conference calls to contain similar discussions.

In fact, if you want a sneak peak into what many companies will most likely be communicating as it relates to the new tax law, I think Cintas did a good job of covering the main talking points. I’ve listed the highlights below.

In general, the tax law is expected to be a net positive.

“There will be significant benefits. As a profitable business with the vast majority of our earnings in the United States, we have historically paid a high tax rate. The reduction in the corporate tax rate will boost Cintas’ earnings and increase cash. Also, we expect many of our customers to benefit from tax reform and invest additional amounts of cash to grow their businesses. Healthy and growing customers are good, of course, for our business. Tax reform will enable us to repay debt more quickly and then have additional cash on hand for our priorities, namely, investments, acquisitions, dividends and share repurchases.”

There will be some adjustments to deferred tax assets and liabilities, or as Cintas states, it will also be an accounting event.

“The signing of the legislation by the President will be an accounting event for Cintas. We will need to revalue deferred tax liabilities.”

Some credits and deductions will be eliminated.

“Well, the — when we think about that kind of an ongoing rate of 23% to 26%, there is a big benefit, obviously, from the drop in the corporate rate. However, couple of things that I might point out. There is something called a Section 199 manufacturing credit that is no longer existing, and that had a small impact on us. There is also the Section 162(m) impact, which is the loss of the deduction for any executive comp over $1 million. That certainly will have an impact. But that’s about it. And certainly then there’s the one time toll charge related to the taxing of foreign E&P.”

And of course, “Could you talk about the cash benefit and how it will be allocated?” will be a popular question. Cintas provided what I expect to be a common response.

“I would say that when you think about the cash flow that we’ve generated in the past, our first priority is to invest in our business. And that’s investing in our business, in our employees, whom we call partners, but then also in capital expenditures, etc. That is always our first priority. The second priority is we will continue to look for M&A opportunities when they make sense at the right value. We will likely continue to look at dividend increases and then share buyback. So I would say that our prioritization hasn’t changed much…”

And finally, it’s a new law and will take time for companies to review and make adjustments.

“We do certainly still need to spend some more time with all of the details. But I would say, over the course of the next couple of months, we’ll likely update our guidance to give some more specific thoughts.”

At this stage of the economic and market cycle, I’m not sure additional stimulus is needed (see Cintas’s 7% organic growth in its uniform business). Nevertheless, the new law is here and we’ll have to wait and see how things unfold (not to mention how long lower tax rates stick – see Political Math).

While I expect corporate management commentary will be positive and earnings will increase, the valuations for most of the businesses I follow will remain well above historical norms. For example, based on my calculation, Cintas’s current P/E of 31x will decline to 27x using its new tax rate – not exactly a bargain for a mature high-quality business.

Although it’s relatively easy to estimate the immediate impact of lower corporate taxes on cash flows, how will other valuation variables be affected? Will rising fiscal deficits and economic growth result in higher inflation and interest rates?

For example, let’s assume economic growth increases from 2% to 4%. What would happen to the 10-year Treasury yield in such a scenario? It would not be surprising if its yield increased accordingly from 2% to 4%. In such a scenario the valuation benefit from a higher growth rate would be offset by higher interest rates.

In my opinion, the current market cycle is highly dependent on the belief interest rates will remain lower for longer. As such, I’m very interested to learn how additional stimulus will influence inflation and if recent upward trends will be amplified (especially labor). In effect, will lower taxes provide enough stimulus to finally jolt the bond market and force central bankers to reconsider their current course of dovish gradualism? And if lower taxes aren’t enough, how about a trillion dollar infrastructure plan? Things sure are getting more interesting!

In summary, I’m looking forward to learning how savings from lower tax rates will be distributed and ultimately allocated. I also plan to monitor its impact on inflation and interest rates. Although I expect earnings and cash flows to increase in the near-term, I believe changes to other valuation variables are equally as important and should be carefully considered in any valuation scenario analysis.

After one of the most uneventful and least volatile years in the history of financial markets, I’m optimistic fluctuating valuation variables will create a less predictable and more interesting market environment in 2018. And who knows, maybe one day we’ll discover volatility in valuation variables has spilled over into asset prices. I don’t know about you, but a touch of symmetry in financial markets sure sounds refreshing to me!

[As I was about to publish this post, a mortgage broker friend stopped by my office (Starbucks). He informed me he made $1,500 in the stock market yesterday and took his gains from last year to join the most exclusive country club in North Florida. He went on to inform me stocks will never go down with Trump in office. He asked what I was doing. I said I was waiting to buy his stocks at much lower prices. We both laughed. He then recommended bitcoin and left my office with a double shot espresso.]

It’s official — we’ve entered the “serenity now!” phase of the market cycle.

Article by Absolute Return Investing with Eric Cinnamond