Image Source: Michael Vadon
By Kris Rosemann and Brian Nelson, CFA
Speculation over which sectors may be the biggest beneficiaries of the incoming Trump administration has been running rampant in recent weeks, and we’ve received questions from members pertaining to this topic, specifically with respect to the utilities and telecom sectors. In fact, an article in the Financial Times, released mid-November, tabbed the utilities (XLU) and telecom (XTL) spaces as two sectors that may be able to generate outsize earnings improvements thanks to a reduced corporate income tax. But will they truly benefit over the long haul? Let’s walk through our take on the impact a potential reduction in corporate tax rates may provide these two areas. It may not all be positive.
Let’s start with regulated utilities. Though regulatory environments differ across the world, rate-setters consider a regulated entity’s cost structure, including estimated income taxes, when assigning maximum rates that regulated utilities can charge for their services to recapture their investments. The profitability of a regulated utility is tied to a fixed-ROE, or regulated return on equity, that is applied to the rate base, and income taxes are an estimated component of the cost structure (rate base) of most regulated utilities. In simplistic terms, a higher rate base means higher regulated earnings, holding all-else equal (a fixed ROE), so higher estimated income taxes in a higher rate base means higher regulated earnings. On the other hand, lower estimated income taxes would translate into lower earnings as a result of a regulated utility’s lower rate base. Regulated utilities are a unique business model in this respect where the more they invest in their rate bases (taxes included), the more earnings they generate, all else equal.
However, it is important to differentiate what may happen to regulated utilities’ earnings streams in the near term versus what may happen over the long haul in the event corporate tax rates are reduced during the Trump administration. It is our view that lower corporate tax rates may translate into a short-term shot in the arm for regulated utility earnings as estimated tax expense falls while rates that they can charge temporarily remain at prior levels (prior rates would have considered the higher tax burden in the rate base). Still, we don’t think this near-term boost would be a big deal for most utility holding company valuations, as most market participants may look past this short-term positive in evaluating the long-term earnings power of a regulated utility to estimate its intrinsic value. Our fair value estimates, for example, consider a utility’s normalized earnings, and a long-term view with respect to utility fundamentals has significantly more weight within our valuation process than any near-term bump that might come from an income tax break, or more specifically an impermanent timing mismatch that artificially enhances a regulated utility’s ROE.
Where the impact on near-term earnings for regulated utilities may be positive as a result of a tax cut, the long-term implications of a tax cut are less clear. For example, under a scenario where the Trump administration lowers tax levels, we would fully expect regulators to work quickly to reset rates such that outsize ROEs won’t last long. We doubt consumers will continue to pay lofty utility bills detached from the cost basis of the regulated utility. They will demand relief, too. Though the magnitude of any impact, whether near-term or long-term, will vary for each regulated utility across our coverage universe, we think the end game is that any tax savings a regulated utility would garner under the new Trump administration would largely be passed to the consumer in the form of lower utility prices as a result of a lower rate base, all else equal.
Looking beyond the near-term boost, it can even be reasonably assumed that the amount of economic profit a regulated utility could create, in aggregate, would be reduced as rate bases are negatively impacted from the lower income taxes themselves, all else equal. The net impact, of course, is much more complicated than just this simple observation, as lower corporate taxes may also enhance the financial flexibility (improve credit) of the utility holding company, and lower implicit tax burdens at the consumer level coupled with increased infrastructure spending initiatives (expected during the incoming Presidential administration) may inevitably help drive rate bases continuously higher even if income taxes act as a short-term rate-base headwind. Utilities that generate a high percentage of unregulated earnings may see a more tangible, sustainable boost from having to pay a reduced amount to the tax man, so the “Trump income-tax question” is certainly a firm-specific one.
Let’s now talk the telecom sector. Some have pegged the sector as one that will benefit the most from corporate tax reform in terms of after-tax income, and in the second quarter of 2016, for example, the sector had the highest average tax rate of any sector, so the group could use some relief from a tax-rate cut. However, a potentially bigger impact on telecom companies’ earnings more so than other sectors may come more from changes in the tax code itself as Trump’s call to expense capital investments and disallow net interest deductions could have profound implications on the group’s reported profitability. Utilities will also be impacted disproportionately relative to other capital-light, cash-rich sectors given utilities’ hefty capital spending and debt-heavy balance sheets, too.
Changes to expense capital investments would be beneficial to telecom and utility companies since they require large amounts of capital spending to build and maintain the infrastructure necessary to operate their businesses. Expensing would bring forward tax deductions today that otherwise wouldn’t be realized for years and years into the future. However, doing away with net interest expense deductions would have a negative impact on the debt-heavy telecoms and utilities, as interest is itself a tax shied. The net impact of these tradeoffs will vary from company to company from sector to sector, depending on the level of annual capital expenditures and the service costs of debt loads. In fact, we won’t know the net positive of each entity until all the details are hammered out, but we think the telecom and utility spaces will be disproportionately impacted by these specific accounting-related considerations.
The telecom industry also expects to benefit from a relaxed regulatory environment, as Trump has promised to, “formulate a rule which says that for every one new regulation, two old regulations must be eliminated.” Industry participants anticipate the Trump administration to be more open to consolidation within the sector, which bodes well for AT&T (T) and its acquisition agreement with Time Warner (TWX). Such expectations are welcome news to industry heavyweights after the Obama administration nixed two wireless telecom deals in recent years but may not appeal to smaller players, who fear of pro-establishment, anti-competition behavior from federal policy makers. In fact, among the largest deals axed by the DOJ have been in the telecom space, and a Trump administration may mark the beginning of the end for their deal-making blues. Chasing trends in M&A, however, isn’t really a sound investment strategy for long-term investors, in our view, even if the Trump administration turns out to be less of a headache than those of prior Presidents.
Corporate tax reform may be more likely than any other time in recent history due to a Republican-controlled Congress and White House, but potential income-tax rate cuts, changes in the tax code regarding the expensing of certain items, and regulatory rollbacks certainly cannot be guaranteed by any President-elect, even if the market is starting to price in probabilities associated with them. This article specifically addresses implications on the utilities and telecom sectors from changes in corporate tax-related considerations, but we continue to be wary of these sectors, in general, particularly in light of the rising interest rate environment, which has sent the 10-year Treasury yield to ~2.5% at the time of this writing. As is well-known, both sectors satisfy yield-hungry investors, but as risk-free rates continue to rise, dividend yields may become less and less attractive within these groups. It is a theme we’ve been emphasizing for the past many months as a cautionary tale to dividend growth investors.
That said, in light of the capital-intensive nature and debt-heavy positions of both the utilities and telecom sectors, they haven’t fit well with our focus on identifying companies that have indisputable financial strength and cash cushions to withstand pretty much anything that is thrown at them or their dividends. We’re still comfortable holding PP&L (PPL) for diversification purposes in the Dividend Growth Newsletter portfolio and the Utilities Select SPDR (XLU) in the Best Ideas Newsletter portfolio, but Trump’s move into the Oval Office won’t do much to alter our opinion on these two sectors, a fundamental view that remains grounded in financial statement analysis. The capital intensity and leverage positions of these two sectors simply won’t go away under a Trump administration, unfortunately.
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Podcast: EVERYTHING DIVIDENDS + 3 TOP IDEAS
The Valuentum analyst team explains the difference between the adjusted Dividend Cushion ratio and its unadjusted counterpart. The success of the Dividend Growth Newsletter portfolio is covered, and Valuentum’s top 3 dividend growth ideas are unveiled. ~13 minutes.
FAQ: Does a ‘Very Poor’ score on Valuentum’s assessment of a company’s dividend safety mean the firm will cut its dividend in future periods?
Not necessarily. In many cases, a ‘Very Poor’ dividend safety score will predict a cut, as this is what the Valuentum Dividend Cushion ratio has been designed to do.
However, in other cases, the Valuentum Dividend Cushion may highlight significant risk related to future dividend payments (but not necessarily suggest that a cut is on the horizon). For one, the assessment of a firm’s dividend safety is based on the excess cash-flow capacity the firm has for future dividend raises after considering its balance sheet structure. By extension, there will be a positive correlation between the safety of a firm’s dividend and its future potential for growth.
In other words, the larger the capacity the firm has to raise its dividend based on our Valuentum Dividend Cushion ratio, the more secure existing dividend payments are. However, just because a firm has a ‘Very Poor’ dividend safety score doesn’t necessarily mean it will cut its dividend anytime soon. What a low safety score does mean, however, is that the board has effectively maxed out the company’s annual payout and has little room for operating error.
In fact, a lot of steady-eddy utilities firms receive a ‘Very Poor’ safety rating. However, based on the stability of their business models (and sometimes fixed rate of returns), we’re not expecting them to cut their respective dividends anytime soon. However, should an exogenous event happen, the board hasn’t left much excess cash-flow capacity to absorb the impact and the dividend may be exposed to significant risk (think of the most recent examples of Exelon and First Energy).
Telecom Services: BCE, CTL, DCM, EQIX, FTR, S, T, TMUS, VOD, VZ, WIN
Utilities (Large): AEP, D, DUK, ED, EIX, EONGY, ETR, EXC, FE, NEE, NGG, OKE, PCG, PPL, SO, XEL
Wireless Telecom Services: AMT, CCI, CCOI, IRDM, LVLT, NSR, SBAC