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Treasury & Taxation

The Downside of Repatriation

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July 21, 2017

A cash repatriation holiday may weaken notion of net debt.

Money compassThe rating agencies have long factored “net debt” into their ratings, the assumption that cash held overseas can be used if necessary to service debt, but tax reform has prompted concerns about the validity of that notion and may result in ratings downgrades.

Standard & Poor’s voiced similar concerns May 30 in a report titled “Mixed Consequences for Nonfinancial US Corporate Issuers,” and the issue was discussed earlier that month at the NeuGroup’s Assistant Treasurers’ Group of Thirty (AT30). Republicans’ dimming efforts to repeal the Affordable Care Act (ACA) will almost certainly turn legislators’ focus toward tax reform, in search of a significant accomplishment before 2018 elections. And even should ACA repeal efforts revive and further squeeze time and resources devoted to tax reform, the component most impacting net debt will almost certainly be a part of a final tax package.

“If we have any tax reform, the likelihood of repatriation being included is extremely high,” said Salvatore Seguna, managing director of strategic solutions at Credit Suisse.

S&P, and to a lesser degree other rating agencies, have incorporated the notion of net debt into their credit analysis, given US companies that operate globally tend to have significant cash offshore. In its report, S&P estimates that the nonfinancial corporates it rates hold $1.9 trillion of cash and investments, with roughly $1.1 trillion overseas, and roughly $5.8 trillion in total debt.

“If tax reform facilitates the repatriation of foreign earnings, we believe that offshore cash balances, for many companies, could begin to burn a hole I management’s pocket and lead to a material amount of distribution of this cash being to shareholders,” S&P’s report says.

The ratings agency notes that a “partial positive” for adjusted leverage would be a lower S&P surplus cash haircut for cash remaining overseas, because current and future foreign earnings would not be subject to US tax under the territorial-based tax system that is anticipated to accompany repatriation. That would increase the rating agency’s surplus cash calculation for offshore cash, but not enough to fully offset potential shareholder returns.

“As a result, we believe the proposals around cash repatriation and a territory-based tax system would likely lead to higher pro forma leverage for US corporations,” the report says.

Essentially, S&P is recognizing that the market may be pricing in companies’ use of significant amounts of repatriated cash to reward investors with more share repurchases and dividend increases. This may be a factor why many stock prices are already reaching record highs. In fact, when asked whether a significant portion of repatriated cash would be returned to shareholders, most AT30 participants at the meeting raised their hands.

Companies’ desire to meet investor expectations and support their elevated stock prices with repatriated cash calls into question the notion of net debt.

“What that means is the net-debt treatment some companies have received all these years may not fully reflect reality, because they don’t plan to de-lever with all the repatriated cash,” Mr. Seguna said.

However, that scenario may be overly simplistic, Mr. Seguna said, since it assumes repatriated cash will be quickly put to work. In reality, much of that money is not sitting in cash or cash equivalents and instead is invested in term government or corporate bonds.

“So it will take time for that cash to be put to use, supporting the view that there will be a more managed approach to decreasing the size of balance sheets over time through both debt reduction and equity buybacks,” Mr. Seguna said.

He added that an important consideration for corporates with a big gap between net and gross debt is that their ability to do significant share repurchases with repatriated cash may be limited by the rating agencies. Consequently, the majority of AT30 members that raised their hands to acknowledge their companies would likely use the cash to reward equity investors may end up not having total flexibility.

And then the question for some becomes, “How does the equity market react?” Mr. Seguna said.

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