It’s likely that no industry has awaited the passage of the Tax Cuts and Jobs Act (TCJA) more than technology. While a strong stock market over the past year suggests that equity investors are bullish about the new tax regime, S&P Global Ratings generally expects it to have a negative impact on our credit ratings on technology issuers. We do not doubt that the companies will improve their cash flows through lower corporate tax rates and gain access to “trapped” foreign earnings through repatriation. However, we believe that the overall industry credit profile will weaken over time, largely because of the potential for more aggressive financial policies in response to greater access to overseas cash. We forecast that this will result in reduction of overall cash balances and ultimately lead to weaker credit metrics for some of our rated issuers.
We view three categories of companies as particularly susceptible to rating actions:
– First are issuers that have both high cash and debt balances but choose to use substantial portions of now-accessible foreign cash for shareholder returns, which could harm credit metrics given our methodology of netting of surplus cash against debt.
– Second are issuers with share prices that have underperformed those of their peers, leading to pressures on management to return excessive amounts of foreign cash to shareholders or undertake risky acquisitions.
– Lastly are issuers with high leverage, because we believe prospects for reduced interest deductibility could reduce free operating cash flow (FOCF), which we view as an important differentiator between ratings at the low end of the rating scale. For companies that are already strong or weak within the current rating, mostly those with positive or negative outlooks, modest changes to our forecasts as a result of revised tax expectations could improve or pressure ratings.
S&P Global Ratings believes that tax reform will fundamentally alter the technology sector landscape and usher in a new world of lower cash balances and flat to lower debt, much of it incurred as a form of synthetic cash repatriation and used for share repurchases, although we note that debt financing remains an attractive option in case of acquisitions. Apple Inc. announced last week that it intends to become net cash neutral over time, compared to its current $163 billion net cash position, implying a significant increase in shareholder returns and perhaps a more aggressive acquisition posture. We anticipate that other large cash holders will also announce enhanced shareholder returns over time. S&P Global Ratings will analyze each issuer’s financial policy changes before considering any rating action. But investors be aware: the technology sector may never look the same again.
Table 1 summarizes the provisions we see as likely to have the greatest influence on creditworthiness of investment-grade and speculative-grade issuers and their directional impact.
Repatriation Of Foreign Cash Is A Game Changer
While the decrease in the statutory corporate tax rate to 21% from 35% has garnered the most headlines among U.S. corporates, we believe repatriation of cash held overseas will have the greatest, and perhaps most immediate, impact on the technology sector’s creditworthiness. If an issuer adopts a more aggressive financial policy than we expect after repatriation, likely through additional share repurchases, its credit metrics could deteriorate based upon our policy of netting surplus cash against debt, potentially leading to rating or outlook revisions. Generally, we will not deduct surplus cash from debt if a company is (1) owned by a financial sponsor as defined in our criteria, or (2) has a business risk profile at the lower end of the scale (i.e., weak or vulnerable as described in our criteria).
Note that under the territorial tax system, we would eliminate or reduce the surplus cash haircut that has been associated with repatriation taxes (previously as high as 35%) which would be an immediate credit positive, but would also add the repatriation tax liability to debt should the issuer choose to pay the tax over time. On the other hand, if enhanced shareholder return is offset by some level of debt reduction, the ratings impact may be neutral to positive.
Specifically, issuers with large net cash positions are likely to return significant amounts of repatriated cash to shareholders, but we do not expect this to lead to meaningful rating actions unless it results in revision of their financial policies. Rather, these borrowers would mostly be reducing their cushion with respect to the ratings (see table 2).
Issuers With High Cash And Debt Balances Face A Dilemma
Unlike issuers with large net cash positions, we believe those that have both high cash and debt balances face potential credit risks because they may choose to use substantial portions of nowaccessible foreign cash for shareholder returns. These issuers, some of which have modest net cash positions or are in net debt positions, will have to manage a delicate balance between equity holders and debtholders. Depletion of cash, if not offset by some debt reduction, can raise leverage by our calculation and lead us to consider a downgrade.
For example, Oracle Corp. has a massive $72 billion cash balance that accounts for about 35% of its market capitalization, but its debt load is also sizeable at $61 billion. As a result, its net cash to market capitalization is modest, at just 5%. Companies such as Hewlett Packard Enterprise Co. and Western Digital Corp. also have cash balances that account for more than 25% of their market capitalization, but are in net debt positions. Intel Corp., despite its $18 billion of cash and investments, has $9 billion in net debt. We believe companies with these types of balance sheets will have to clarify their financial policies to both equity and bond investors over the coming quarters as cash comes back on shore.
Issuers With Underperforming Stocks Will Be Pressured
We are very attentive to the repatriation-related earnings call comments from issuers whose share prices have underperformed the overall market during the past year. Issuers with meaningful cash balances offshore are likely engaged in deep board-level discussions to finalize their capital allocation strategies and we have already heard from some management commenting about “return of excess capital” to shareholders. We believe that management of companies whose share prices have lagged the market will feel greater pressure to appease the shareholders through aggressive share repurchases or risky acquisitions.
On Jan. 30, 2018, Juniper Networks Inc., whose stock underperformed the S&P 500 IT Index by more than 30% over the past year, announced a $2 billion stock buyback authorization, including a $750 million accelerated share repurchase agreement, and a 80% increase to its dividends, to be partly funded by $3 billion repatriation of foreign cash. Juniper has a strong net cash position of nearly $2 billion and we expect the company to maintain a strong balance sheet through the enhanced shareholder return campaign. Nevertheless, we believe there is significant pressure on the management of such companies that could lead them to prioritize equity investors instead of maintaining sufficient dry powder for future acquisitions or industry cycles.
Table 5 indicates selected companies whose stocks have outperformed the market overall. While we expect these outperformers to also increase shareholder returns with what they consider to be excess cash, we believe that they will have more flexibility around the timing and size of the returns, with greater likelihood that they will balance the needs of both stock and bond holders.
Lower Corporate Tax Rates Benefit Most, But The Impact Will Be Modest Overall
While we expect the decrease in the statutory corporate tax rate in 2018 to 21% from 35% will benefit the majority of technology companies, the size of the benefit is partially dependent on each company’s previous effective tax rate. We expect conservatively leveraged, profitable, U.S.-focused companies are most likely to have relatively high effective tax rates, but only a small portion of rated U.S. technology companies meet that profile. This is because the conservatively leveraged companies (those often rated investment grade) tend to be large multinational companies with significant overseas operations, and the U.S.-centric companies generally tend to be smaller and more aggressively leveraged, often owned by private equity sponsors. Some technology companies with a relatively high effective tax rate are highlighted in table 6.
Large technology companies generally have lower effective tax rates because they generate significant profits abroad and book them in low tax jurisdictions where much of their intellectual property is based. We believe these issuers generally have effective tax rates of 20% to 25%. They stand to benefit from lower U.S. corporate tax rates, but we note that these benefits could be partially offset by other tax provisions, such as global intangible low-taxed income (GILTI), which will effectively force affected companies to pay higher taxes (at an effective rate of 10.5%, before credit) on low-taxed foreign income going forward.
On the other hand, we do note that some large companies, mostly hardware and semiconductor issuers with significant U.S.-based operations, have reported in their most recent earnings calls that their effective tax rates will decline meaningfully. Intel Corp., which has significant manufacturing operations and research and development (R&D) spending in the U.S., announced that its effective tax rate could decline to about 14% from the low-20% area. Texas Instruments Inc., a major exporter of semiconductor chips with significant manufacturing, R&D, and intellectual property in U.S., also forecasted that its tax rate would drop nearly 10% to about 18%. These revisions represent meaningful upside to future cash flow, although we suspect that much of this benefit will flow to shareholders over time. Table 7 shows median effective tax rates for selected technology companies.
As for speculative-grade issuers, especially in the ‘B’ rating category dominated by smaller private equity owned companies, we expect that the lower corporate tax rate will bring only nominal benefits as the majority report low effective tax rates or net losses. Many of these highly levered issuers also have significant net operating losses, recent changes from TCJA notwithstanding, that shield them from paying taxes.
Speculative-Grade Issuers With Significant International Operations Disproportionately Hurt By Limit On Interest Deductibility
While the lower corporate income tax rates are clear benefits to companies in the technology sector, the limit on interest deductibility undoubtedly hurts highly leveraged technology companies, especially those with significant overseas operations.
TCJA limits net interest deductibility at 30% of taxable EBITDA for tax years 2018 through 2021. For tax years beginning in 2022, the provision would become even more unfavorable to highly leveraged companies as the limitation adjusts to 30% of EBIT. Since most rated U.S. technology companies issued debt at their domestic entities, while a lower proportion of consolidated income is generated in the U.S., the limitation could raise the U.S. federal income taxes of companies that have significant international operations.
About 75% of total rated issuers in the technology sector are speculative grade-rated, rated ‘BB+’ or lower, many of them private-equity owned and saddled with significant debt. We expect the limitation on interest deductibility, without consideration for other provisions within the TCJA that could have compensating effects, to raise the U.S. federal income tax and reduce FOCF generation of some rated U.S. technology companies, especially those in the ‘B’ rating category. Although any disallowed interest is permitted to be carried forward indefinitely and could be used for future deductions if interest drops below the 30% limit, we do not view this to be a meaningful offset.
We do not anticipate any negative rating actions to investment-grade rated U.S. technology companies as a result of this TCJA provision. However, for U.S. technology companies rated ‘B’ or lower, where FOCF generation and liquidity profile provide key ratings support, we could lower ratings if we find credit metrics deteriorate meaningfully. The companies’ U.S. federal income tax position will determine the impact of the interest deductibility provision. For example, companies that currently generate significant operating losses in the U.S. might not experience an impact on their FOCF by the disallowance of the interest deductibility limit. Also, companies could carry forward 80% of net operating losses from prior periods to reduce their U.S. federal income tax burden, minimizing the negative impact to their FOCF.
We believe the interest deductibility limitation will have wide-ranging effects on highly leveraged U.S. technology companies and on how private-equity owners evaluate potential leveraged buyout (LBO) targets. We expect U.S. technology companies to consider issuing debt at foreign subsidiaries and reduce debt issued at their domestic subsidiaries. We also expect companies to reduce their existing debt, if possible, as their net cost of financial leverage increases for the same amount of financial risk. As for the impact on private-equity owners, we expect the interest deductibility limitation to lead to downward pricing pressure on LBO transactions, which could result in lower debt leverage at portfolio companies.
We believe the factors most likely to drive rating actions differ for investment-grade and speculativegrade rated companies. For speculative-grade rated companies—many of which have high leverage and operate predominantly in the U.S.--we believe rating changes are most likely at the very low end of the rating scale, given the weak credit metrics already associated with many companies rated at this level and the prospects for thinner free cash flow for some given changes to interest deductibility rules.
As for investment-grade companies, we believe the most significant factor likely to lead to a rating change is the potential for foreign cash balances to be used for share buybacks. We expects cash-rich issuers to gradually outline their repatriation strategies through 2018, detailing the size and pace of shareholder returns as well as potential changes to long-term capital structure. We do not believe that large technology issuers desire to maintain the current level of cash on their balance sheets and will increase share repurchases to right-size their cash positions. We also believe that some companies will work to reduce their debt levels, much of it incurred as a form of synthetic cash repatriation and used for share repurchases, by retiring upcoming debt maturities and halting new debt issuances given they will have greater access to global cash flow going forward. Ultimately, we believe that balance sheets will shrink for many issuers. As the technology industry matures, we believe more issuers will take on balance sheets similar to those of traditional industrial companies, with less net cash or even net debt positions.