Revisiting Excess Cash in the Technology Sector
In August 2013, we provided an analysis of excess cash on the balance sheets of four technology holdings: Apple, Inc. (AAPL), Juniper Networks, Inc. (JNPR), Microsoft Corp. (MSFT), and Cisco Systems, Inc. (CSCO)1. Nearly three and a half years later, the balance sheet remains a meaningful source of value at each of the four companies. Additionally, we have initiated investments in Alphabet, Inc. (GOOGL), the parent company of Google, Inc., which has accumulated $83.1 billion of cash and marketable securities, and Cognizant Technology Solutions Corp. (CTSH), a provider of information technology (IT) services, which has accumulated $4.9 billion in cash and short-term investments. While our projections of the future earnings and free cash flow account for the majority of our estimate of the intrinsic value of each business, excess cash may not be fully reflected in current market prices. Revisiting the extent to which cash on the balance sheet represents a source of value at each company may prove timely if President-elect Trump follows through on his plan to lower the rate at which corporations are able to repatriate foreign profits that have not yet been taxed by the United States.
Tax Policy and Repatriation
Under current tax laws, profit recognized outside of the United States is taxed in the foreign jurisdiction immediately, but is not taxed by the U.S. government until the cash is returned to the United States. Because many of the countries in which the profit is recognized have lower corporate tax rates than the U.S., corporations benefit in the short term by paying less income tax. However, when the cash is returned to the U.S., it is taxed at roughly the difference between the 35% U.S. corporate tax rate and the tax rate that was already applied in the country in which the profit was recognized. Reluctant to pay this additional tax, many companies have elected to keep overseas cash in the foreign jurisdictions rather than repatriating the cash to the U.S. and paying the additional tax.
The most recent repatriation holiday, The Homeland Investment Act of 2004, allowed companies to bring profits earned in foreign jurisdictions back to the United States at a 5.25% incremental U.S. tax rate. According to the Internal Revenue Service, 843 companies repatriated a combined $312 billion as a result of that legislation. President-elect Trump’s tax plan2 proposes a one-time 10 percent tax on the repatriation of corporate profits that are currently held outside of the United States. An opportunity to repatriate overseas cash at a favorable repatriation tax rate would likely be viewed positively by many companies in the technology sector, and could result in a significant amount of overseas cash returning to the U.S. Once overseas cash is repatriated, it is reasonable to believe that it could be either invested into the businesses at favorable rates of return, or returned to shareholders via share repurchases or dividends. The table that follows details the extent to which cash, net of debt, represents a source of value at six technology companies that are owned by Diamond Hill. For the purposes of this analysis, a 10 percent tax is applied to cash held by foreign subsidiaries.
Use of Repatriated Cash
While the Homeland Investment Act of 2004 was designed to stimulate domestic investment, employment, and research and development, the repatriated cash may not have increased investment in these areas to the extent that might have been anticipated. A prominent study released by the National Bureau of Economic Research3 found that each dollar of cash that was repatriated was associated with a $0.92 increase in capital returned to shareholders, primarily through share repurchases. This occurred despite the legislation being designed with the intent of preventing the use of repatriated cash for dividends and share repurchases. However, money is fungible, and in practice the availability of additional cash resulted in additional capital being available for dividends and share repurchases. It is possible that future legislation could more effectively prohibit the use of repatriated cash for dividends and share repurchases, but regardless, it would be a positive for companies with large overseas cash balances to have the option to repatriate that cash at a lower tax rate than is typically applicable.
Despite the technology sector likely being a major benefactor of a potential repatriation tax holiday, shares of many technology companies have underperformed the broader market following the election. Concerns over potential changes to the H-1B visa program, which is widely used by technology companies to employ high-skilled foreign workers within the U.S., as well as concerns that a more protectionist approach to global trade could negatively impact both the production and sale of technology products, have offset some of the optimism associated with a potential repatriation tax holiday. The impact of each of these items must be assessed on a company-by-company basis, and we believe that our deep knowledge of each business positions us well to estimate intrinsic values and identify investment opportunities during periods of legislative change.
While there is inherent uncertainty associated with the specific timeframe within which each company may elect to repatriate overseas cash, recognizing the value of cash is likely to prove worthwhile for investors. A 10 percent repatriation tax holiday could compel many technology companies to repatriate significant amounts of overseas cash and invest it to grow the earnings power and intrinsic value of their businesses or return the cash to shareholders. We believe that excess cash on the balance sheet remains an important source of value at several of our technology holdings.
|(In $ millions, except share and per share amounts)||Apple||Cisco||Alphabet||Microsoft||Cognizant||Juniper|
|Cash and Cash Equivalents||20,484||8,583||9,406||13,928||1,550||1,689|
|Total Cash and Investments||237,585||70,968||83,056||147,418||4,859||3,480|
|Cash Held by Foreign Subsidiaries||216,000||60,600||49,700||111,100||3,728||3,167|
|% of Total Cash and Investments Held by Foreign Subsidiaries||90.9%||85.4%||59.8%||75.4%||76.7%||91.0%|
|10% Tax on Cash Held by Foreign Subsidiaries||(21,600)||(6,060)||(4,970)||(11,110)||(373)||(317)|
|Total Cash and Investments Net of Tax||215,985||64,908||78,086||136,308||4,486||3,163|
|Other Notes and Borrowings||—||—||—||—||—||—|
|Net Cash and Investments||128,953||30,119||74,148||61,618||3,589||1,030|
|Diluted Shares Outstanding||5,393||5,066||698||7,876||609||385|
|Net Cash and Investments per Share||$23.91||$5.95||$106.16||$7.82||$5.90||$2.68|
|Stock Price as of 11/30/2016||$110.52||$29.82||$775.88||$60.26||$55.08||$27.54|
|Percentage of Stock Price in Net Cash and Investments||21.6%||19.9%||13.7%||13.0%||10.7%||9.7%|
3 Dhammika Dharmapala & C. Fritz Foley & Kristin J. Forbes, 2011. “Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act,” http://www.nber.org/papers/w15023
As of November 30, 2016, Diamond Hill owned shares of AAPL, JNPR, MSFT, CSCO, GOOGL, and CTSH.
Originally published on December 14, 2016.
The views expressed are those of the research analyst as of December 2016, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.