AT&T, Caterpillar, and Deere are among the companies that are reporting large first-quarter accounting charges because of the repeal of a tax deduction by the new health-care law. But the charges will have little effect on company valuations or cash flow, analysts say.
The Patient Protection and Affordable Care Act strips companies of a 28% tax deduction related to retiree drug benefits. The deduction is actually the tax-free treatment of a government subsidy that companies receive for providing retiree drug benefits equivalent to Medicare Part D, says tax expert Robert Willens, who heads a consultancy in New York. Since the deduction can't be claimed until the benefits are paid out, companies make the adjustment by writing down the deferred tax asset balances related to the subsidy, notes Willens.
Under the new law, the subsidy is no longer tax-free and must be included in a company's taxable-income calculation. The law eliminates the "double dipping" possibilities that were part of the tax code since 2003, says Willens. Under the original Medicare prescription-drug law, companies received deductions for making payments into retiree drug plans, as well as getting tax-free treatment for the subsidies they received for paying into the plans.
Last week AT&T announced it plans to take a $1 billion noncash charge related to the new law in the first quarter. Also announcing first-quarter charges were Caterpillar ($100 million), Deere ($150 million), and AK Steel ($31 million). Steelcase and DTE Energy also said they would be subject to similar accounting charges, although they have not yet specified the amounts.
A study of S&P 500 companies by Credit Suisse shows that the new law will cause companies to reduce their deferred tax assets by an aggregate $4.5 billion, with 45 of the companies possibly seeing a charge that is more than 10% of their consensus first-quarter earnings estimates. However, investors should not "overreact" to the potential earnings hit, cautions Credit Suisse's David Zion, because the charge will have very little effect on company valuations.
Indeed, the "eye-popping" numbers being reported are not a good indication of the costs being incurred in the first quarter, notes study co-author Christopher Cornett. That's because a quirk in the accounting rules requires companies to recognize the present value today of future cash costs going out as far as the drug benefits are offered. "So that's a big number," says Cornett. (Accounting rules mandate such current-period true-ups when tax-code changes require accounting adjustments to items that are already on the balance sheet, he explains. In most cases, an ongoing future cost would be recognized every quarter, year after year.)
Rather than looking at the first-quarter charge relative to quarterly earnings, Credit Suisse recommends that investors look at the charge relative to the company as a whole, using market capitalization. Zion says that the ratio of earnings charge to market capitalization is a "pretty good proxy" for how much company value should drop as a result of the tax change. Only 8 of the 500 companies studied will register a decrease in that ratio greater than 0.5%, according to Credit Suisse.
The Credit Suisse report also points out that corporate cash flows from operations won't suffer much from the loss of the tax deduction, either. Between 2013 and 2019, it's likely that 20 companies will pay more than $5 million per year, on average, of additional taxes as a result of the new law. However, the tax hit amounts to less than 1% of the trailing five-year average cash flow from operations for each of the companies. "In fact, we estimate that there aren't any companies in the S&P 500, where the annual tax hit is more than 1% of trailing cash flow from operations," says the Credit Suisse report.
