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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 |
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*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 companys 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 Siegels bosses knocked him off when he didn't have a pile for them. The bosses figured that if they didnt 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 companys 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 companys 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 |
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| 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 |
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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 |
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The taxing standouts
The relative quality of a companys 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)
Harrahs 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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