Archive for March, 2010

Healthcare Legislation to Severely Impact Cash Flows and Valuation

March 25th, 2010

From Caterpillar’s 8K released today:

As a result of the Patient Protection and Affordable Care Act (H.R. 3590) signed into law on March 23, 2010 (the “Act”), beginning in 2011 the tax deduction available to Caterpillar Inc. (“Caterpillar”) will be reduced to the extent its drug expenses are reimbursed under the Medicare Part D retiree drug subsidy (RDS) program. Although this tax increase does not take effect until 2011, Caterpillar is required to recognize the full accounting impact in its financial statements in the period in which the Act is signed. As retiree healthcare liabilities and related tax impacts are already reflected in Caterpillar’s financial statements, the change will result in a charge to Caterpillar’s earnings in the first quarter of 2010 of approximately $100 million after tax. This charge reflects the anticipated increase in taxes that will occur as a result of the Act. As mentioned on page A-106 of Caterpillar’s Form 10-K for the year ended December 31, 2009, Caterpillar’s 2010 Profit Outlook is based on tax law in effect as of February 19, 2010 and does not include the impact of the Act.

The recently approved healthcare legislation will have a material impact on cash flows not currently reflected in stock prices. Companies like Caterpillar, P&G, 3M, and IBM, which have a high ratio of retired and near retired, to an active workforce, will be most affected by the rise in cash taxes. But almost all firms will be impacted.

We have reviewed our model portfolio, and believe other investors will be doing the same. The result will be an increase to cost of capital which will reduce valuation multiples.

As firms have been able to show large reductions to pension plan liabilities, resulting from the large rally in stocks during 2009, with commensurate improvement to shareholder’s equity, the healthcare law will refocus investors to the benefits area. If the 2009 valuation benefit is not repeated, the cost to S&P 500 companies will be in the many billions of dollars.

And if the reduction in valuation multiples causes stocks to falter, as we expect, the health care legislation will turn out to be a very costly.