Thursday, April 12, 2007

How You and Me Are Going to Outfox Max Baucus

Greg Mankiw has a post today rebutting Robert Frank's dismissal of marginal tax rate reductions. I am not going to wade into that technical discussion except to say that it is fun to watch academic economists dress up in jargon and debate, again, whether incentives matter. This post did however prompt me to post about a dinner I had the other night (where coincidentally Ned Phelps was sitting at the next table over from me...reducing his, or his companions', savings in lieu of a little consumption, namely of expensive wine, Williams-Selyem Pinot Noir to be precise). Anyway, at the dinner I was chatting with a large shareholder of a small company about recapitalization options. The company in question has a large amount of cash, very little debt and not much of an appetite for acquisitions. So how should we go about returning that cash to shareholders? Buy in shares? Maybe but that increases the equity holders' stakes increasing their reliance on a liquidity event someday, which may or may not be doable, depending on economic conditions, before 2010 when the 15% capital gains tax rate goes up. Why tee up a potentially much higher tax bill? Pay a dividend? Fine. Regular or one-time special? Well, if you commit to a regular dividend, you expose investors to the increased dividend tax rates when the 15% rate also goes up in 2010. A special dividend looks like the way to go. You can determine the precise amount of excess cash and control the timing, so shareholders can get a hefty payout at the 15% rate. OK, done, the big shareholder will discuss it with the Board of Directors.

That's when it hit me. I probably knew in a vague sense the consequences, but at that moment it crystalized for me. It is so obvious. Hundreds if not thousands of company's will be recapitalizing in 2009, paying out huge special dividends just before the dividend tax rate goes up. Many will lever up and many will cease dividends altogether post 2010 and use the cash flow to reduce the debt, in essence pulling profits forward in time to give their shareholders cash at the 15% rate and reduce the level of future profits that would be subject to higher rates of taxation. Imagine that, receiving your little slice of US corporate profitability for years 2011-2015 in 2010, cash money! The implications for the Treasury are that there will be a surge of revenue in 2010 and a cratering of revenue beyond. Private equity types are doing this already. When the outlook for capital gains is cloudy (or even when it is not) they sell bonds to pay themselves a fat dividend. As 2010 approaches, everybody will be getting in on this game. You've got to own stocks to get your share of the cash tsunami but massive capital losses would be in the offing. Start learning now about buying long dated puts on the market indices and/or selling calls.

Furthermore, congress will interpret the revenue surge as a permanent increase in the tax base, and they will rapidly increase spending. The post 2010 federal budget deficits could be huge when the tax receipts dry up. With guys like Max Baucus at the wheel, I say it's a safe bet. Won't be good for treasuries.

With treasuries and stocks looking bad, usually what happens is capital flows to real estate (think 2002). I think it is fair to say that 2011 is far enough away for the collective memory of where we are today with real estate to have faded by then. I predict another real estate boom circa 2012.

7 Comments:

Blogger anicolici said...

That's gotta be one of the best crystal-ball reads of all time. Hats off!

11:49 AM  
Blogger Tom said...

Interesting bit of speculative thinking. But I wouldn't bet the farm on your scenario.

12:48 PM  
Blogger rufus said...

I sure wouldn't bet the farm against it!

2:56 PM  
Blogger CapitalGain said...

A one-time "bubble" payout is a bad idea. GM used to do it with its Q4 "extra" and it did absolutely nothing to improve the longer-term/intermediate-term valuation (p/e) of the company.

Assuming a negative tax scenario beyond 2010, I'd rather have a share buy-back that permanentlly shrinks the market cap and gives me a permanent boost to EPS.

3:18 PM  
Blogger Donny Baseball said...

CapGain-
You would rather that but alot of hedge funds will agitate for my scenario.

4:15 PM  
Blogger Tax Shelter said...

WOW, nice post! Bear markets in both stocks and bonds in a few years!? Ouch. By real estate, I hope you actually meant “hard assets”, not housing?

With regard to special dividend vs stock buyback… Let's see... if we assume that 1) shareholders buy and sell regularly on a LT basis, and 2) company would take on no additional debt, 3) the cash portion of the balance sheet is valued properly by the market already, then we have: old market cap = market value of assets - market value of liabilities = assets ex cash + cash - liabilities

Scenario I - special dividend:
pre-dividend payout, shareholders get old market cap.
Post-dividend payout, new market cap = assets ex cash - liabilities ex debt + debt = old market cap - cash. Shareholders get cash + new market cap = old market cap. So, no change in shareholder value.

Scenario II - share buyback:
pre-buyback, shareholders get old market cap.
Post-buyback, shareholders get new market cap = old market cap - cash + cash value of equity. New market cap should be very similar to old market cap.

Under the current tax law (15% on both LT capgains and dividends), scenario I & II seem interchangeable. But if I were the shareholder, I would prefer scenario II because scenario I only makes sense near the end of the year 2009. Between 2007 and 2009, the cash on the company's books would be a drag on performance. If the company decides to return the cash in the form of dividends now, then it would a) force every shareholder to take on reinvestment risk, and b) lose a boost to EPS from the management’s perspective. In contrast, buying back shares now is a win-win strategy, i.e., it would make both the management and shareholders happy (don’t forget, before 2010, shareholders can always create their own dividend, at anytime, by selling a portion of their shares).

9:15 AM  
Blogger mtliberty said...

For some reason, I'm not offended (as a Montana voter) when Mr. Baseball runs a micro-takedown to include the senator I didn't vote for. Keep up the good work.

3:04 AM  

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