In the face of U.S. tax reform, identifying the winners and losers among the 2,200 U.S. corporate borrowers S&P Global Ratings rates is quite a complex task. We see the potential effects as mostly positive, but they’ll vary significantly depending on a borrower’s historical effective tax rate, the sectors and industries in which it competes, whether it holds sizable amounts of cash overseas, and—perhaps most importantly—any resulting shifts in financial policy.
While corporate borrowers are still actively working to assess the impact, we see five key takeaways based on our early discussions and preliminary assessments:
Ratings Changes Likely Won't Be Significant
Despite improved cash flows in most sectors, our preliminary assessment indicates that fewer than 10% of ratings could be subject to change as a result of the tax reform. And the actual number of ratings changed will most likely be even less than that. This is due to our expectation that companies won’t use much of the extra cash for permanent debt reduction, and so leverage tolerance levels will be mostly unchanged. As a result, we believe reform-related ratings changes of more than one notch will be rare, and upgrades and downgrades are both equally likely. While some upgrades will stem from sustained improvements in credit metrics, downgrades could result from either the direct negative effects of tax reform or shifts in financial policy.
We expect the main beneficiaries of tax reform—investment-grade issuers and cross-over credits— to use the majority of incremental cash flow and overseas cash for dividends and buybacks, capital investment, and M&A. Any resulting effect on the ratings will largely depend on the impact on leverage and how any capital investment and M&A might affect business risk profiles. Overall, we expect that the majority of investment-grade issuers won’t meaningfully alter their financial priorities or leverage tolerance levels in pursuit of a higher rating. For example, based on increased confidence in its balance sheet due to tax reform, Comcast Corp. recently stated that it would sustain leverage at about 2.2x as opposed to lowering it. Similarly, we expect Apple Inc.’s use of its roughly $163 billion of surplus cash balances to be heavily skewed toward share repurchases.
By contrast, companies more negatively affected by tax reform—or those with less-optimal capital structures under the new tax regime—might pursue debt repayment and deleveraging to a greater degree. However, despite the increase in the after-tax cost of debt, we don’t envision sweeping changes to capital structures. More likely, issuers will make incremental adjustments, especially when deciding how to address interest-deductibility caps.
In addition, improvements in funds from operations (FFO) don’t necessarily translate into a commensurate improvement in FFO-to-debt ratios and, ultimately, higher credit ratings (see “U.S. Tax Reform: An Overall (But Uneven) Benefit For U.S. Corporate Credit Quality,” Dec. 18, 2017). For example, a 20% improvement in FFO on a company with $100 million of debt might result in only a 200-basis- point increase in FFO to debt, assuming no change to the capital structure. In addition, while FFO to debt might improve, we can’t be certain this will mean improvements in either free cash flow or discretionary cash flow because companies could increase capital expenditures, dividends, or both.
We do not expect to make any changes to our corporate criteria, methodologies, or financial risk profile ranges, which are global in nature and include foreign jurisdictions with comparable tax rates to the new 21% U.S. statutory rate. While tax reform could—in some cases—lead to a divergence in FFO to debt and debt to EBITDA, our criteria provide the flexibility to use a number of ratios in our assessments, including supplemental ratios such as FOCF to debt and DCF to debt. Decisions regarding which ratios most accurately reflect an issuer’s credit profile would be made by committees on a company-by-company basis.
In terms of timing, we expect minimal ratings actions prior to financial disclosures being released and us assessing them thoroughly. Rating changes due to a shift in financial policy or M&A could develop over the course of 2018 as companies revise capital-allocation strategies.
A Case Of The Strong Getting Stronger
In our view, the positive effects of tax reform will be greater for investment-grade borrowers (those rated ‘BBB-‘ and higher) than for speculative-grade ones ( ‘BB+’ and lower, which account for about two-thirds of the rated corporate universe). And highly leveraged borrowers will benefit little. In fact, for borrowers with EBITDA-to-interest ratios below 2x, we estimate that on average, the impact on FFO will be neutral to negative (see Chart 2).
The credit implications on specific sectors will vary, with certain ones disproportionately affected by certain provisions. The table provides a sector heat map outlining our early expectations regarding the direction and magnitude of the credit impact for the main provisions of tax reform. While most of the results are intuitive, certain sectors and outcomes are worth highlighting.
For companies, the jewel in the tax-reform crown is the lower tax rate—with the corporate statutory tax rate falling to 21% from 35%, starting this year. Moreover, the lower rate is permanent, unlike the cuts for individuals and so-called pass-through entities. (The owner of a pass-through entity reports the business’s income on his or her individual tax return; some estimates say these constitute 95% of American businesses.) Sectors with higher historical effective tax rates—such as media and entertainment, business services, and health care—would benefit most from the drop in the statutory rate, while for regulated utilities, the lower tax rate would actually be a credit negative (see “U.S. Tax Reform Will Present Challenges For Utilities,” Jan. 24, 2018).
But many of the corporate borrowers we rate won’t benefit to the extent that a 14-percentage-point drop in the statutory tax rate would suggest. This is because historically, many companies have taken advantage of various deductions and deferrals, effectively paying well below 35%. In fact, according to the Treasury Department’s Office of Tax Policy, the average effective corporate tax rate from 2007-2011 was just 22%. In 2014, it was 24%—only marginally higher that the 21% for companies headquartered in the other Group of Seven (G-7) countries.
The immediate expensing of qualified property is another credit-positive provision, though the incremental benefit must be assessed in the context of previous bonus depreciation rules. Accordingly, the credit benefit is mainly low to medium across most sectors, with more capital-intensive sectors such as autos, telecommunications, and unregulated utilities realizing a higher benefit on average.
Perhaps most surprising is that limits on interest deductibility, a clear-cut negative provision of the legislation, might have a more muted credit impact than originally expected. Within the oil and gas sector, for example, we expect tax reform to have a low impact due to the extensive net operating losses (NOLs) many issuers have accrued over the last few years. While we expect limits on interest deductibility to initially apply to roughly half of our speculative-grade universe (using EBITDA as a proxy for adjusted taxable income), many highly leveraged issuers—especially those that have undergone leveraged buyouts—currently don’t pay taxes. We estimate that roughly 30% of our speculative-grade issuers don’t, though tax changes could cause companies to exhaust NOLs faster.
Finally, repatriation taxes and a shift to a territorial tax system will have a mixed impact on credit quality but are more relevant for a handful of sectors. Overall, for sectors with large overseas cash balances—such as technology and health care—we believe these provisions will lead to companies choosing to permanently reduce cash positions over time, as evidenced by Apple’s announcement that it plans to eventually become net cash-neutral. This could fundamentally alter the landscape of these sectors and lead to weaker liquidity, less-flexible balance sheets, and tighter cushions against downgrade thresholds over time.
The Secondary Effects Of Tax Reform
We expect that the tax reforms could also have secondary effects that affect credit quality. Most obvious are potential shifts in financial policy, especially considering that companies will likely face more activist pressure to return cash to shareholders. Because we net surplus cash against debt for companies with fair or better business risk profiles, permanent reductions in cash positions could weigh on ratings over time and leave companies with less cushion to absorb unexpected credit deterioration or acquisitions. In addition, we believe that greater access to foreign cash balances could weaken discipline around M&A at a time when valuation multiples are trending higher.
Another secondary effect is the potential increase in debt issuance by U.S. companies at foreign subsidiaries that are not U.S. tax filers. Specifically, companies dependent on interest deductibility could evaluate issuing debt in high-tax foreign jurisdictions that allow interest deductibility. Some companies have already explored this option, and we believe others will follow suit as they examine ways to avoid interest-deductibility limits. How any new foreign borrowings affect the recovery prospects of existing debt instruments will ultimately depend on a few key factors: the amount of foreign debt raised, the terms of this debt, and—perhaps most importantly—what they do with the proceeds. For example, overseas borrowings will decrease the value of foreign equity that flows back to U.S. secured and unsecured creditors, though foreign borrowings could be structured to improve the collateral value captured by secured bank lenders if there is a collateral sharing mechanism to equalize foreign and domestic borrowings. Ultimately, domestic unsecured borrowings are more likely to be harmed than helped by increased foreign borrowings.
The Effects On S&P Global Ratings’ Ratios Will Be Mixed
Regarding S&P Global Ratings’ ratios, we will capitalize repatriation taxes paid over an eight-year period within our adjusted debt calculations. If an issuer chooses to pay the liability over time, we would typically add to debt the net present value (NPV) of the liability by discounting it by 7% (see “Corporate Methodology: Ratios And Adjustments,” Nov. 19, 2013). That is, we add to reported debt- incurred liabilities that provide no future offsetting operating benefit. The ability to pay repatriation taxes over up to eight years will partially mitigate the effects on cash flow, though some companies might have to borrow if they have permanently reinvested foreign earnings. In addition to the debt adjustment, we will make an add-back to FFO for the one-time repatriation tax liability that companies will be recording as a current tax expense in their annual or quarterly financials.
Given the shift to a territorial tax system, we will also eliminate the portion of our surplus cash haircut related to repatriation taxes; in certain cases, this could more than offset the tax liability in our adjusted net leverage. Accordingly, the net impact of repatriation taxes and a shift to a territorial tax system on S&P Global Ratings-adjusted leverage will ultimately depend on the use of cash balances.
Other impacts on adjusted ratios include tax-effecting liabilities at the lower 21% statutory rate for U.S. entities versus 35%, which will increase S&P Global Ratings-adjusted debt. We will begin using a 21% rate for pensions and other post-employment benefits and asset-retirement obligations for the fiscal quarter and annual period containing Dec. 31, 2017.
We expect that rating actions due to tax reform won’t be significant and will most likely result from secondary effects revolving around financial policy. Accordingly, there could be some ratings actions over the course of 2018 as companies make decisions regarding their capital-allocation and capital- structure strategies.
On a sector basis, while the net impact of tax reform is largely positive, certain sectors—such as technology and health care—will have more mixed results due to a longer-term reduction in overseas cash positions. Meanwhile, sectors such as oil and gas will see a low impact across the board. In addition, while limits to interest deductibility constitute a clear-cut credit negative, a large number of issuers that find themselves over the 30% caps have NOLs that will help prolong any impact from these provisions for a number of years.
As companies continue to provide further disclosure, we see the highest probability of near-term rating actions among issuers that either demonstrate a change in financial policy, highly leveraged issuers that can’t avoid the effects of interest-deductibility limits, and companies already on the cusp of a higher or lower rating. Over the course of 2018, we could see further actions as companies revise their financial policies and further refine their capital structures.