Thanks to Tax Reform, Retailers With Strong Cash Flows Will Soar

The U.S. statutory corporate tax rate was reduced from 35% to 21% at the beginning of 2018. That's particularly good news for retailers, which historically haven't been able to take advantage of many tax breaks to lower their effective tax rates.

In this segment from Industry Focus: Consumer Goods, Vincent Shen is joined by senior contributor Adam Levine-Weinberg as they look at the potential tax savings for some of the most prominent U.S. retailers. Kohl's (NYSE: KSS) is one company that is set to realize significant savings, which it could use to increase its dividend or ramp up share buybacks.

A full transcript follows the video.

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This video was recorded on Feb. 13, 2018.

Vincent Shen: Let's move on, then, to our main topic for today. Fools, Adam originally approached me last month, and he pitched the idea of covering the new tax plan, specifically the changes to the corporate tax rate. For the major retailers that we often discuss here on the show, the sector has been cited by many publications and analysts as a space that will benefit more than others from the new tax rate. Adam, since you pitched the idea to me from the get-go, I'll let you take it away. Can you give our listeners a rundown of some of the reforms that went into effect last month, and also why there is an outsized impact for retailers?

Adam Levine-Weinberg: Absolutely. The big headline of the corporate tax reform that went into effect at the beginning of 2018 is that the statutory federal tax rate, so the base tax rate, was reduced from 35% previously to 21% going forward. That's a pretty significant decline there. However, a lot of companies weren't actually paying a 35% effective tax rate. There's a whole host of tax credits that existed under the previous tax law, and some of those still exist.

Companies that have a lot of international sales and earnings have been able previously to shelter that money by keeping it overseas and reinvesting it there. That's why you've seen companies like Apple keep so much cash abroad. So some tech firms have had very low effective tax rates in the past. By contrast, retailers really haven't been able to take advantage of any of these tax benefits under the old law. If you look at most retailers, they're very heavily concentrated in the U.S. for sales and especially for their earnings, and they don't have many tax breaks, so they're paying effective tax rates, when you include state taxes as well, of 37% and 38%. Those are typical numbers there.

Shen: I'll jump in there with some examples. You combine the fact that retailers, most of their operations are based in the U.S., so they generate the bulk of their revenue here, with that income being largely subject to the higher U.S. tax rates. And also, they just don't get access to as many of those tax credits and deductions that you mentioned, Adam. I have some specific examples that generally highlight what we've described so far. These are the effective rates for some of the bigger retailers out there.

Starting with Wal-Mart, they generate about 70% or so of their revenue in the U.S. Their effective tax rate for the trailing 12-month period came out to 31.8%. Its rival, Target, they note in their 10-K that virtually all of their revenue is generated within the United States. Its effective tax rate was 31%. And then, for the department stores, Nordstrom, Macy's and Kohl's are also all predominantly U.S.-based businesses, and their effective tax rates all came out in the range of 36% to 40%. Even TJX Companies, which has Canadian and international segments that they break out that account for about 25% of sales, that company is still reporting an effective rate of 37.2%.

So you compare those rates that I just mentioned with the broad U.S. effective tax rate from the Congressional Budget Office, that came out to 18.6%. So you can see that retailers are, indeed, paying higher rates, and thus in a position to benefit from this new tax plan. With some of those broader details in mind, Adam, I know you wanted to focus on how different companies might take advantage of their cost savings specifically. What did you have in mind?

Levine-Weinberg: I basically would group it into, there's two different categories here of retailers that will do well. The first are retailers that have very high cash flow already relative to their market cap. And then the other would be retailers that have relatively high capital spending budgets. We'll go through both of those in order.

On the cash flow side, when you look at retailers that have low price to free cash flow ratios, basically the tax cuts made a lot of these stocks, which were already pretty cheap, even cheaper. The typical benefit for a company that was paying a 37% to 39% effective tax rate previously, the benefit of moving to this new tax structure is probably worth about 20% more earnings per share on an after-tax basis. So even if their pre-tax earnings stay exactly the same in 2018 compared to 2017, you're going to see really strong earnings growth. So a company that might have been trading for 10x earnings before is now at something like 8x earnings. That makes these cheap stocks even cheaper. And to the extent that they haven't yet corrected, there's definitely some upside for investors there. And I would put a lot of department store companies into that category.

On top of the valuation aspect, companies with a high free cash flow are now going to have extra firepower because of the lower tax bill, to pay more dividends, to buy back more stock, or to reduce their debt. So Kohl's is a really great example of this. As we talked about on our last show last month, Kohl's reported 6.9% comp sales growth during the holiday period, which was its strongest result in over a decade. It's already doing really well -- it's already making the investments that are necessary to transform the business. The extra cash that it's now going to bring in from paying a lower tax rate, there's not much that it should do with it other than start returning it to shareholders. So I think you could see either a nice dividend increase this year or higher share buybacks, or potentially both.

Shen: And I just wanted to quantify the potential windfall that Kohl's will enjoy. Assuming its effective tax rate falls from 37%, which was the latest I could find for the trailing 12-month period, to about 23%, that's an additional $144 million in earnings that can potentially flow to the bottom line.

Adam Levine-Weinberg owns shares of Apple, Kohl's, Macy's, Nordstrom, and The TJX Companies and has the following options: short February 2018 $160 calls on Apple. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Nordstrom and The TJX Companies. The Motley Fool has a disclosure policy.