Tax Reform Could Be Boon for Financials, but Impact Is Uneven

Corporate tax reform would generally be a material positive for the financial sector, although we believe the benefit will not be evenly distributed. In our scenario analysis, the best-positioned companies could see their valuations increase as much as 35%, while other companies could see only a minimal impact. In our view, companies with economic moats will be better able to hold these gains. Further, companies with domestically focused operations and limited use of existing tax shields will see a stronger benefit. However, we also see knock-on effects that could shift market share and force corporate reorganizations.

U.S. corporations are currently taxed at a statutory rate of 35%, the highest among the Organization for Economic Co-operation and Development nations and one of the highest in the world. In addition, U.S. corporations face taxation at the state and local level at an average of approximately 4.1%. Moreover, the United States is the only country that has adopted a worldwide system of taxation. As such, U.S. corporations face the prospect of being taxed not only on their earnings related to U.S. domestic operations, but also for activity related to their subsidiaries overseas (less applicable credits for taxes paid to foreign nations). However, U.S. corporations can indefinitely defer taxes on their overseas earnings unless cash is repatriated to the U.S.

Republicans enjoy control of both chambers of Congress as well as the White House. However, this does not necessarily translate into legislative consensus on taxation. Both President Donald Trump and Congress want tax reform, but each side has formulated its own plans for how best to approach it. Compounding this is the lack of a filibuster-proof Republican supermajority in the Senate. As a result, Republicans have indicated their willingness to push forth comprehensive tax reform through the budget reconciliation process. Because of certain nuances to this procedure, any tax reforms ultimately agreed to would have to conform with certain spending and revenue targets, as well as other budget rules and laws.

Trump and the GOP agree that U.S. corporate tax rates should be cut, as did former President Barack Obama and certain Democrats. The main impetuses for a cut include improving U.S. competitiveness and curtailing the threat of tax inversions. Where all parties differ, however, is the extent to which rates should be slashed. Trump is in favor of reducing the corporate tax rate to 15%, whereas the House GOP has proposed a reduction to 20%. In our sensitivity analysis, we run three tax rate scenarios: 15%, 20%, and 25%. The first two scenarios reflect the Trump and House GOP plans. The 25% rate scenario reflects an outcome where the proposed rate cut is curtailed by the need to hit revenue targets or to gain buy-in from Democrats.

Regarding the tax treatment of capital expenditures, the House Republican proposal would change the current norm by allowing for the cost of capital investment to be fully and immediately deductible, obviating the need for depreciation schedules for tax purposes. It would also eliminate interest deduction. Under Trump’s plan, manufacturing firms would be given an option between full expensing of capital expenditures and deducting interest expense. Eliminating interest expense deductions is a necessary byproduct of any proposal to permit full expensing of capital asset purchases. Otherwise, a tax arbitrage situation would occur whereby companies would doubly benefit from better-than-consumption tax treatment.

Is unclear how these rules would be applied to the financial sector. The House GOP plan says its Way and Means Committee will develop special rules regarding interest expense in the business models of financial service firms. Their business models make it difficult to separate debt from reinvestment, as debt is more akin to a raw material than a source of capital. Even interest expense from corporate debt versus customer deposits, for example, would be difficult to distinguish.

Additional proposals would allow repatriation of U.S. corporate cash held overseas. The similarities between the two camps' proposals appear to end there, however. Trump would allow a one-time repatriation of currently deferred foreign profits at a rate of 10%. While the president has not yet specified, presumably this would revert to a normalized corporate tax rate. The House GOP plan, in contrast, would impose a deemed repatriation of currently deferred foreign profits on cash and cash equivalents at a rate of 8.75% and 3.5% on other profits.

Perhaps the most pronounced differences between the plans pertain to the U.S. worldwide system of taxation. The House GOP plan would create a fully territorial tax system, exempting 100% of dividends derived from foreign subsidiaries from U.S. taxation. Trump’s tax plan originally would have ended deferral. Recent iterations have appeared to walk back this proposal as the president has added more conservative tax advisors to his team. Either way, assuming Trump’s preferred rate is implemented, it would appear the distinction between a worldwide or territorial system would matter little. Ireland would be the only OECD country with a lower tax rate, and there are only so many Irish companies a U.S. corporation could conceivably acquire.

Another difference is the House GOP’s proposal to institute a border-adjustable tax. Trade was an area of focus during the presidential campaign, and the House GOP plan is meant to address the growing trade imbalance with other nations through the federal tax code. Under this plan, all business income tax would be border-adjustable, disallowing the deduction for purchases from nonresidents and exempting export profits and foreign-derived profits from taxation. In other words, the corporate tax code would solely levy tax on business transactions from the sale of goods and services within the borders of the U.S. It remains to be seen whether this would be acceptable under current World Trade Organization rules, as some believe that the House GOP measure is akin to a hidden tariff. Trump has criticized the plan as too complicated and alluded to his preference for levying overt tariffs on imports. A number of prominent Republican senators have also recently expressed their displeasure with the proposal.

Tax Reform Mostly Good News for Banks, but Impact Will Vary We see banks with a wide or narrow moat rating, limited international exposure, limited use of tax-advantaged investments and other tax shields, and limited exposure to corporate lending as the biggest beneficiaries of reductions in tax rates

Among large banks, the sizable consumer banking businesses at

Among regional banks, we think

With only 22% of its loan book in consumer loans,

Among the country’s largest banks, Wells Fargo stands out from a valuation standpoint. The company currently trades at a discount to our fair value estimate and is well positioned to benefit from potential changes in the tax regime. Wells Fargo has been troubled by the late 2016 scandal regarding its sales practices, contributing to its recent stock underperformance. On this front, too, Wells could see relief from a change in the regulatory environment. Though financial repercussions have been limited to date, a decline in regulatory attention would help the firm repair its brand in the eyes of its customers.

Most regional names we cover are currently trading above our fair value estimates, and we believe this is largely due to the market already pricing in a very good chance of a tax cut. However, if a cut to 15% were to go through, we believe there would be at least 10% or more upside to BB&T,

Significant Spread of Outcomes for Insurers, and Potentially Some Losers With only about 10% of the global market, the U.S. is a relatively small player in property and casualty reinsurance, a situation we largely attribute to a relative tax disadvantage, particularly in relation to Bermuda. The Bermudan reinsurance market in P&C insurance lines is actually 50% larger than the market in the rest of the Americas, a share that is dramatically out of line with the island's economic importance. Significantly lowering the U.S. tax rate could help to level this playing field and push some reinsurance underwriting back into the U.S., allowing domestically domiciled reinsurers to gain share.

Within our coverage, we see

Within our domestic insurance coverage, we see a relatively wide spread of outcomes from lower tax rates. Franchises fully centered on the U.S., such as

Chubb, with 40% of its premiums generated outside the U.S. and its Swiss domicile, would see relatively little benefit.

For investors looking to exploit tax reform specifically, we think

Tax Reform Would Be Timely for Asset Managers The traditional U.S. asset management industry is facing a multiyear period of fee and margin compression, as their primary retail distribution channels—broker/dealers and advisors--are focused more than ever on investment performance and fees and are already culling platforms to eliminate poorer-performing and more costly actively managed funds. Given this, a reduction in the statutory U.S. federal income tax rate can't come soon enough, as it will help to offset the impact of these pressures, ensuring that cash flows don't fall off too precipitously. Still, while these firms tend to be asset-light and are not balance-sheet-driven like the banks and insurers, they will carry debt from time to time. As such, not being able to deduct interest expense could prove problematic for firms carrying somewhat higher debt balances.

Within our coverage of the U.S.-based asset managers, we see a fairly wide band of potential outcomes from corporate tax reform, with firms generating a greater percentage of their pretax income domestically tending to benefit more from a reduction in the corporate tax rate.

Wide-moat companies that generate a larger percentage of their profits in the U.S., like

While a handful of the U.S.-based asset managers--Eaton Vance, T. Rowe Price,

We don't see any dramatic opportunities, but on the basis of its wide moat, domestically focused operation, and current valuation, we think T. Rowe Price looks like the best target for investors looking to exploit tax reform. The stock is modestly undervalued based on current tax rates and has significant upside.

Tax Reform Could Prompt Structural Change for Alternative-Asset Managers Criticism of tax rules on carried interest has come from both parties, and reform has long been a divisive issue in alternative-asset management. Trump has made it clear that he plans to raise carried interest tax rates to closer to corporate tax rates.

Carried interest generated by alternative-asset managers, primarily via private equity investments, is currently taxed at 23.8% (20% tax on net capital gains plus a 3.8% investment tax for high-income earners), whereas management fees and other are taxed at higher regular corporate tax rates closer to the 39.6% top tax rate on earned income. Under the new administration, we believe the most likely reforms are that the carried interest tax rate will increase to 33% from 23.8%, whereas corporate tax rates (meaning tax rates on management fees) will decline to the low 20s on average.

Given these changes, we believe the publicly traded alternative-asset managers will seek to shift to a more attractive corporate tax structure. We acknowledge that this shift will mean that earnings will be subject to double taxation, versus being passed through to the unitholder. However, at a corporate level, we see three major benefits: retaining similar (if not more) earnings for reinvestment in the business, multiple expansion, and index inclusion. We think multiple expansion will also be aided by the fact that investors seem to prize the stability of management fee income more so than incentive income and have awarded it a higher multiple, and tax rates for management fees should decline as they will be subject to the new lower corporate tax rate.

Our fair value estimates for the alternative-asset managers have long included a long-term tax rate of 35%, recognizing that the current carried interest tax situation was untenable over the long term, even if there were no immediate threats on the horizon. We understood that investors would probably demand a discount to account for the threat. As a result, changing our tax rates for the industry doesn’t necessarily result in a material shift in our fair value estimates, as we believe the more influential factors for investors will be more technical, such as the broadening of the investor base, the potential for index ownership, and increased earnings growth via higher reinvestment in the business, among other items.

Our top ideas are wide-moat

We believe the shift will have a minimal financial impact on results for the industry, but the upside could be significant, as we think industry multiples could rerate closer to traditional asset managers in the 15- 17 times earnings range, from around 8-10 times now, given many institutional investors' reluctance to invest in master limited partnerships owing to tax complexity, liquidity, or mandated restrictions on MLPs. Index inclusion for some of the largest names in the industry, such as Blackstone or KKR, would be an added boost in visibility. In addition, simply having clarity on the carried interest tax issue--which has been around for a decade and is meaningful, as carried interest can generate more than 50% of a manager’s income--will help remove investor concerns. Other multiple-enhancing benefits include a large opportunity for the firms to reinvest more of their capital in businesses that generate 20%-plus returns on equity, by our estimates, and the opportunity to take advantage of lower tax rates on management fee income, which investors have consistently prized and valued the most highly, in our view. This shift would probably value firms more highly under a sum-of-the-parts model, which sell-side analysts often use to value the industry.

Smaller Investment Banks, Brokerages Would Be Biggest Tax Cut Winners

While all of the investment bank and brokerage stocks that we cover would benefit from a straight corporate income tax cut, the ones that would most benefit are the smaller, domestically focused firms. Small- and mid-cap investment bank and brokerage stocks with 15% or more upside in a 20% U.S. tax rate scenario include

Additionally, there’s the potential that tax law changes, such as the lower tax rate on repatriated cash, could spur acquisition activity. Raymond James and Stifel Financial would benefit from tax law changes; however, the status of the Department of Labor’s fiduciary rule is an additional regulation that investors should monitor.

While Greenhill’s and

Changes in tax laws could spur Lazard to change its corporate structure. Lazard is a publicly traded partnership, which keeps some investors at bay as they don’t want to deal with the tax complications associated with a Schedule K-1 tax form. We know that management has considered the idea of becoming a C-corporation; a lowering of the U.S. corporate tax rate and changes to how foreign income is taxed could tip the balance in favor of changing into a C-corp.

Changes in U.S. tax policy are likely to have the least effect on Goldman Sachs and Morgan Stanley. From a pure U.S. corporate tax rate perspective, they’re relatively global companies, with about 60% and 70%, respectively, of their revenue coming from the Americas. They might see uplift in financial advisory from companies making acquisitions after repatriating of cash or increased equity capital raising if the interest expense deduction on corporate debt is eliminated. That said, investment banking revenue is only about 20% of net revenue at Goldman Sachs and 15% at Morgan Stanley, so there would have to be a significant increase in investment banking to move the needle for the entire company.

Stephen Ellis, Jim Sinegal, Greggory Warren, CFA, Michael Wong, CFA, CPA, and Joshua Aguilar contributed to this article.