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The Speculator
A
warning sign of corporate woes?
In a search for signals that could tip us off
to accounting trouble, we compared earnings with taxes actually
paid. We found, surprisingly, that companies paying bigger tax bills
often do better than those paying less.
By Victor
Niederhoffer and Laurel Kenner
Everybody calls me a racketeer. I call myself a
businessman.
-- Al Capone
Many once-impeccable
companies have recently found themselves in very hot water. Global
Crossing and WorldCom represent just two of the most prominent
corporate accounting debacles.
Surprisingly,
both of these companies displayed great earnings right up to the
moment they imploded. Or, perhaps, that's not so surprising given
what we know now.
There was, however, one sign of trouble
that in retrospect appears to be rather intriguing. Strangely, both
Global Crossing (GBLXQ,
news,
msgs)
and WorldCom (WCOEQ,
news,
msgs)
reported very high annual earnings before interest, taxes,
depreciation and amortization (EBITDA) and taxes relative to the
actual cash taxes that they paid:
| 2 taxing tales |
|
EBITDA, 2001 |
Cash tax paid, 2001 |
| Global Crossing* |
$4.12 billion |
None |
| WorldCom |
$7.1 billion |
$148
million | | *Results are for first three quarters of 2001; 4Q
statement has not been filed.
The ratio of these two
numbers provides a nice measure of, shall we say, Enhanced Cash
Flow, or Investor-to-Government Success. Dare we call it "The
Expansiveness Ratio" or the "Book-to-Pay Ratio"? We'll explain below
how this ratio works.
Search for
warning signs
Why did these companies' balance-sheet
shenanigans take so long to come to light? More to the point, are
there any warning signs that savvy investors -- such as our readers
-- can use to avoid stock losses, if not to actually short such
companies? Is there an objective method we can include in our
repertoire to inform our future investing decisions?
We think
there is such a method.
We looked to see if there is a
relationship between how well a company’s stock will perform based
on how much of its income, as reported to shareholders, is actually
paid in taxes.
Could it be, we wondered, that the amount of
taxes actually paid by a company relative to its reported earnings
is a good indicator of how much financial chicanery is going on
behind the scenes? After all, nothing is more hateful to a company
than not making money and having to pay taxes on it.
Opposing goals
There is nothing wrong in
principle, or even suspicious, about a company reporting one income
to the government and another to the public. Even the mobsters of
early Las Vegas understood this. As reported by Susan Berman in her
book, "Lady Las Vegas," when the mob guys divvied up the casino
takings, there would be a pile for the bosses, a pile for themselves
and a pile for the government. Bugsy Siegel’s bosses knocked him off
when he didn't have a pile for them. The bosses figured that if they
didn’t get their pile from Bugsy, he was either mismanaging their
assets or stealing from them. In either case, he was a liability
they wanted removed.
Companies have two opposing goals:
reporting as little net income as possible to the IRS -- thereby
limiting tax liability -- while reporting as much net income as
possible to the investing public. Indeed, companies are sometimes
required to report different incomes. Keep in mind that the
purpose of financial statements is to provide an accurate financial
picture on which others, including investors, can base their
decisions. The purpose of income tax laws, on the other hand, is to
provide the government with revenue. As a result, the rules the IRS
uses to calculate a company's income and tax liability can differ
significantly from the rules (GAAP, or generally accepted accounting
principles) the SEC requires companies to use when calculating the
income they report to the public.
There are many legitimate
reasons why a company’s taxable income will differ significantly
from the income it reports to its shareholders: the depreciation
method the company uses, the treatment of amortizing intangibles,
the way revenues are “booked” and, interestingly, whether and how
stock options are "expensed.”
Typical journal entries for a
company reporting $1 million in tax expense, of which $200,000 is
current taxes payable and $800,000 is deferred for future years,
would be as follows:
- Tax expense: $1,000,000
- Deferred tax liability: $800,000
- Current taxes payable: $200,000
No accounting for taxes
Accounting for
income taxes is one of the most technical, controversial and fuzzy
of all accounting areas. One generalization that we can make,
however, is that growing companies will tend to have growing
deferred tax liabilities. Growing companies are continually making
new capital expenditures (buying more trucks, for example) and as a
result, the deferred tax liability account on their balance sheet
will continue to expand.
We can also say that various
long-term liabilities will appear on a company’s balance sheet
depending on how it chooses to handle the difference in timing and
the ultimate estimated realization of when the deferred tax
liability or credit is likely to be realized. This timing may vary
substantially under the differing IRS and GAAP guidelines, and can
on occasion -- but by no means all occasions -- determine how
aggressive or conservative a company is with respect to how it
reports taxes on its financial statements.
Our study
While we do not want to imply
that there is anything illegal going on at companies simply because
they report high earnings and pay very low cash taxes, we thought it
might be interesting to study how the stocks of such companies fare
compared with those who pay relatively high cash taxes on the same
income.
We decided a good place to start would be to take the
30 Dow Jones Industrial Average stocks and compare their EBITDA from
their income statements to the cash taxes paid on their cash-flow
statements. We then separated them into two groups, high-tax payers
and low-tax payers, and compared stock performance year-to-date. The
interesting results are shown in the table below.
| High-tax payers |
| Name |
Ticker |
EBITDA, 2001 (in 1,000s) |
Cash Paid, 2001 (in 1,000s) |
Ratio, EBITDA/Tax Paid |
% Return YTD |
| Hewlett-Packard |
HPQ |
3,200 |
1,159 |
2.8 |
-37.6 |
| Exxon Mobil |
XOM |
29,000 |
9,855 |
2.9 |
-13.8 |
| Home Depot |
HD |
5,700 |
1,685 |
3.4 |
-45.5 |
| Procter & Gamble |
PG |
7,000 |
1,701 |
4.1 |
13.4 |
| Wal-Mart Stores |
WMT |
13,400 |
3,196 |
4.2 |
-17.7 |
| Boeing |
BA |
6,500 |
1,521 |
4.3 |
4.3 |
| Johnson & Johnson |
JNJ |
9,500 |
2,090 |
4.5 |
-11.8 |
| Coca-Cola |
KO |
6,200 |
1,351 |
4.6 |
3.4 |
| Philip Morris |
MO |
18,000 |
3,775 |
4.8 |
5.8 |
| Merck |
MRK |
11,500 |
2,300 |
5.0 |
-18.8 |
| Walt Disney |
DIS |
4,600 |
881 |
5.2 |
-32.0 |
| McDonald's |
MCD |
4,000 |
774 |
5.2 |
-13.4 |
| 3M |
MMM |
3,300 |
520 |
6.3 |
3.3 |
| Alcoa |
AA |
3,500 |
548 |
6.4 |
-30.1 |
| Caterpillar |
CAT |
2,500 |
379 |
6.6 |
-17.8 |
|
|
|
|
|
|
|
|
|
|
Average Stock Performance |
-13.9 |
|
|
|
|
Standard Deviation |
17.5 | |
| Low-tax payers |
| Name |
Ticker |
EBITDA, 2001 (in 1,000s) |
Cash Paid, 2001 (in 1,000s) |
Ratio, EBITDA/Tax Paid |
% Return YTD |
| IBM |
IBM |
16,100 |
2,279 |
7.1 |
-43.8 |
| Intel |
INTC |
8,900 |
1,208 |
7.4 |
-43.8 |
| SBC Comm. |
SBC |
20,000 |
2,696 |
7.4 |
-35.0 |
| United Tech. |
UTX |
3,700 |
497 |
7.4 |
1.4 |
| DuPont |
DD |
3,500 |
456 |
7.7 |
-5.1 |
| International Paper |
IP |
3,300 |
333 |
9.9 |
-5.5 |
| Microsoft |
MSFT |
13,000 |
1,300 |
10.0 |
-30.4 |
| American Express |
AXP |
6,800 |
545 |
12.5 |
-8.5 |
| General Motors |
GM |
23,000 |
1,843 |
12.5 |
-12.3 |
| Citigroup |
C |
31,600 |
2,411 |
13.1 |
-37.7 |
| Honeywell |
HON |
1,100 |
79 |
13.9 |
-8.7 |
| Eastman Kodak |
EK |
1,900 |
120 |
15.8 |
0.9 |
| General Electric |
GE |
27,400 |
1,487 |
18.4 |
-24.4 |
| AT&T |
T |
15,600 |
803 |
19.4 |
-49.2 |
| J.P. Morgan |
JPM |
11,200 |
479 |
23.4 |
-32.3 |
|
|
|
|
|
|
|
|
|
|
Average Stock Performance |
-22.3 |
|
|
|
|
Standard Deviation |
17.7 | |
Counterintuitively
-- which suggests that the finding is deserving of much closer
scrutiny -- the companies that paid less tax on the same amount of
income did worse than the companies that paid more. The high-tax
payers were down about 14% this year, while those on the low end
were down 22%. You would expect that companies better able to avoid,
or at least put off, paying taxes would be better managed and thus
have higher performance. Our studies suggest the reverse at a
statistically significant level.
To make sure our results
were not due to chance, we decided to run the test on a sample group
of S&P 500 ($INX)
stocks. We took the first 50 S&P 500 companies, alphabetically
for want of any other arbitrary selection, and broke them into two
groups as we did with the Dow stocks. Again the high-tax payers
significantly outperformed the low-tax payers.
| S&P500 sample
results |
| 50 of 500 |
|
| High-tax payers |
|
| Average performance |
-15.7 |
| Std Dev |
24.9 |
| Count |
25 |
Low-tax payers |
|
| Average |
-31.0 |
| Std Dev |
24.6 |
| Count |
25 | |
The taxing standouts
The relative
quality of a company’s earnings has always been important, but
apparently less so when a raging bull market clouds investors’
judgments.
It might be interesting for our readers to know
on the basis of our study which companies are the champions in terms
of paying the most taxes relative to reported earnings and which are
the most abstemious with their contributions to the IRS. We
emphasize, again, that we are not praising, blaming or questioning
the management or financial statements involved.
We merely
report that for the 71 companies of the S&P 100 ($OEX)
for which we were able to find current Bloomberg data on cash taxes
paid, the five companies that paid the most taxes relative to
earnings were:
EMC Corp. (EMC,
news,
msgs)
Rockwell
Automation (ROK,
news,
msgs)
Hewlett-Packard (HPQ,
news,
msgs)
H.J.
Heinz (HNZ,
news,
msgs)
Exxon
Mobil (XOM,
news,
msgs)
The
five companies that paid the least taxes among this group
were:
Raytheon (RTN,
news,
msgs)
Harrah’s
Entertainment (HET,
news,
msgs)
Entergy
Corp. (ETR,
news,
msgs)
Hartford
Financial Services (HIG,
news,
msgs)
Delta
Air Lines (DAL,
news,
msgs)
Each of the latter five companies, as far as we can tell,
paid no taxes, received a tax credit, or received a tax refund.
Inspired by this example, we cannot resist reporting three
companies that reported the greatest earnings relative to taxes
paid, with ratios in the 47 to 72 area, namely:
Cisco
Systems (CSCO,
news,
msgs)
Allegheny
Technologies (ATI,
news,
msgs)
El
Paso (EP,
news,
msgs)
Acknowledgment
We wish to acknowledge
the able assistance of our colleagues Adam Robinson and Patrick
Boyle in analyzing, calculating and summarizing the data for this
column. This is a very preliminary study. It is quite possible that
during other periods and other regimes, companies paying less tax
and thereby gaining greater cash-flow advantages would outperform.
Final note
Louis Lamour's
character Chick Bowdrie and Pat O'Brian's Jack Aubrey both share
many of the same characteristics that are transferable for
investment success. They loved their vehicle of transportation,
worked to make it the best, were completely hands-on people, were
masters of deception and tracking, and were quite handy when going
for the jugular with the guns, swords and fists.
They both
were completely honest, persistent and loved by their employees.
We wonder if there are any other great literary characters
that any of you know that might provide a model for
investors.
We plan to write in the near future about select
literary characters and the lessons they offer for investors. Your
contributions would be most appreciated; e-mail them to The
Speculator.
At the time of publication, Victor
Niederhoffer and Laurel Kenner did not own or control shares of any
of the securities mentioned in this article.
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