Taxes—An Important Cash Flow Metric

November 15th, 2010 by hackel Leave a reply »

Taxes are an important focal point of securities analysis due to its scope, size, as well as its direct and measurable impact on cash flows. Taxes impair current and prospective operating cash flows because it is imposed on residual profits, after a series of adjustments and credits; the only question is the degree. Investment projects are always considered on an after-tax basis, considering both the income tax effect and the financing effect. Special tax incentives may also impact the hurdle rate and project return on invested capital (ROIC).

Because taxes are not imposed on its income an enterprise pays as interest to creditors, the income tax system creates a bias in favor of debt financing. This bias often results in the overuse of leverage by some firms, and a greater probability of bankruptcy.

A change in the marginal tax rate will influence the amount of capital firms invest by changing the cost of debt capital. This is because the tax shield will either become larger or smaller, resulting in greater or diminished project free cash flow.

Taxes are thus an important metric in CT Capital’s cost of equity capital model as it reflects the decisions and results of all operating, financial and investing activities.

Example –Arch Capital (ACGL) and MetLife (MET)

An interesting study is MetLife (MET) and Arch Capital (ACGL), both insurers, with Arch Capital benefitting from it being a Bermuda based corporation. While these firms’ business models within the insurance sector are somewhat different, they both ride the ups and downs of the industry cycle.

Arch Capital, by virtue of it being Bermuda based (where there is no income or capital gains tax) with US subsidiaries, with the latter divisions subject to paying taxes, enjoys a substantial advantage over MetLife.  Land taxes and payroll taxes are paid in Bermuda and, while they are higher than the US, are considerably lower than the income taxes that would have been otherwise payable.

As seen in the table below, Arch has been enjoying both a low effective and cash tax rate, including income and excise taxes. Its effective and cash rate are remarkably close and stable. Because of the low-tax rate, there is also greater incentive for Arch to issue preferred shares.

In the event that legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on any capital asset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to Arch or any of its operations until March 28, 2016.

The United States imposes an excise tax on insurance and reinsurance premiums paid to non-U.S. insurers or reinsurers with respect to risks located in the United States. The rates of tax, unless reduced by a tax treaty, are four percent for non-life insurance premiums and one percent for life insurance and all reinsurance premiums.

Tax rate stability has not been a hallmark of MetLife, which despite a higher effective rate in 2009, remained cash rate negative, and shows both volatility in the cash and effective rate with a considerably large discrepancy between the two than does Arch Capital. In CT Capital’s credit models, Arch Capital’s cost of capital received a slight penalty to its cost of capital due to its Bermuda status and the possibility that prospective tax rates could rise if that benefit was reduced or eliminated.

In general, for insurers, tax-exempt securities and lower foreign income tax rates and other credits (i.e., employee) will typically keep the cash tax rate below the statutory rate. (For a complete analysis on the subject of taxes, please refer to Security Valuation and Risk Analysis.)

While investors should generally only buy, over the long term, insurance companies on the basis of their underwriting results (loss and combined ratio), other factors can come into play which will influence operations, including the level of interest rates. Today, low rates are one such factor. Other periods it may be catastrophes, which can be a large for any given quarter.

CT Capital does not attempt to predict extraordinary events or interest rates, preferring to concentrate on the normalized cycle. By doing so, it is able to “stress test” management decisions during the down cycles and periods of higher rates—do they write unprofitable business? Are they unnecessarily exposed to unhedged derivatives? By taking this normalized, risk-averse approach, the investor will find himself making purchase decisions at attractive entry points, as was in our case with Arch, which came onto CT Capital’s buy list during July, 2005.

Arch has been a positive cash flow generator in each year shown, unlike MetLife—a strong attribute of stable income tax rate payers of the effective and cash rate.  The difference in cost of capital, of which tax analysis is an important component, became apparent during the credit crisis culminating in the performance gap seen in the illustration below.

Cash and Effective Tax Rates-MetLife and Arch Capital

 

Stock Price Comparison-MetLife and Arch Capital

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Disclosure: No positions

Kenneth S. Hackel, CFA
President
CT Capital LLC

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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” (McGraw-Hill, 2010).

 

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