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Equity Strategy Focus Point
Death and tax reform

Bank of America Merrill Lynch

Quantitative Analysis
29 January 2017 Corrected

Deep dive on corporate tax reform
OK, maybe it’s not as inevitable as death and taxes, but some form of corporate tax reform seems likely. It is a stated priority of President Trump and has widespread Congressional support. We here focus on four components that could have big equity implications. We assess the impacts at a market, sector, and industry level, and plan to update and augment this work as more details come to light.

Potential near-term boost to EPS, long-term impact varies
Our 2018 S&P 500 EPS estimate of $137 already implies healthy two-year growth of +16%. Tax reform in its entirety could add as much as $5-6 to near-term EPS, as benefits are front-loaded. The sustained impact depends: under a 20% tax rate, the Blueprint would be modestly accretive; under a 15% rate, this annual benefit could triple; but a 25% tax rate that would appease the deficit hawks could shave $3.50 off of earnings each year. We also estimate a one-time $8-9 charge to GAAP EPS associated with the repatriation tax (Table 1).

Cutting corporate tax rate could add $8 to EPS
Our starting point is the US statutory corporate tax rate. If it were lowered from 35% to 20% and the US moved to a territorial tax system (no longer taxing foreign profits), it would boost S&P 500 EPS by an estimated 12% ($17 to 2018 EPS). We assume companies would be able to retain half of the benefit ($8) and the remainder would be passed on to customers or competed away. For instance, a lasting impact to Utilities' profits is unlikely, as the benefit would be passed on via regulated pricing.

Repatriation: Buybacks could boost EPS by 3%
Both Trump and the Blueprint support a mandatory (as opposed to 2004’s optional) tax of overseas earnings of US firms’ subsidiaries at reduced rates. Non-Financials in the S&P hold at least $1.2tn in overseas cash (mostly Tech and Health Care). If half was used for buybacks, this could add 3% ($4) to S&P 500 EPS. A redux of 2004 where companies used 80% of cash for buybacks may be less likely, in our view. For if repatriation is accompanied by an end to interest expense deductions, companies may choose to pay down debt over buybacks.

Border adjustment tax (BAT) hits EPS by $5-6
While Trump has described the BAT as being “too complicated,” White House press secretary Spicer’s recent comments call into question his stance. This is a key component of the Blueprint and would generate significant revenue. First-order impacts could be significant, with border adjustments detracting $5-6 from 2018 EPS — nearly 80% of the drag comes from the consumer sectors. The second order impacts — product pricing, pricing within the supply chain, exchange rates, foreign policy reactions, etc. — while harder to quantify, are important to consider.

End to interest deductibility could detract 4% from EPS
We estimate that over time, the removal of the interest expense deduction would detract about 4% from S&P 500 EPS. An increase in the cost of debt by an incremental 25% could have longer term ramifications for capital structures and funding..

Tax reform winners and losers
We include stock screens for potential beneficiaries and victims of tax cuts, repatriation and interest deductibility changes, as well as industries most helped/hurt most by a BAT. Note that the very fact that there are companies and industries that have the potential to be very negatively impacted could call into question the likelihood of passage.

BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
Refer to important disclosures on page 26 to 27.
Timestamp: 29 January 2017 12:01AM EST

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Equity and Quant Strategy
United States
The First 200 Days

Savita Subramanian
Equity & Quant Strategist
MLPF&S
+1 646 855 3878
savita.subramanian@baml.com

Dan Suzuki, CFA
Equity & Quant Strategist
MLPF&S
+1 646 855 2827
dan.suzuki@baml.com

Marc Pouey
Equity & Quant Strategist
MLPF&S
+1 646 855 1142
marc.pouey@baml.com

Alex Makedon
Equity & Quant Strategist
MLPF&S
+1 646 855 5982
alex.makedon@baml.com

Jill Carey Hall, CFA
Equity & Quant Strategist
MLPF&S
+1 646 855 3327
jill.carey@baml.com

Jimmy Bonilla
Equity & Quant Strategist
MLPF&S
+1 646 556 4179
jimmy.bonilla@baml.com

Table 1: Estimated impact of tax reform on S&P 500 2018 EPS
Tax policy | 15% | 20% | 25%
Tax rate change | 10.50 | 8.00 | 5.00
End int. deduct. – init. impact* | -0.50 to -1.00 | -0.50 to -1.50 | -0.50 to -2.00
Border adjustments | -4.00 | -5.50 | -6.50
Repatriation buybacks | 4.00 | 4.00 | 4.00
Total Init. Impact | 9.50 to 10.00 | 5.00 to 6.00 | 0.50 to 2.00
End int. deduct. – recur. impact | -3.50 | -5.00 | -6.00
Recurring impact | 7.00 | 1.50 | -3.50
One-time repat. tax | -8.50 | -8.50 | -8.50
Source: BofAML US Equity & Quant Strategy, FactSet, Compustat, S&P
*Assumes end to interest deductibility only applies to new debt, where we estimate 70-90% of debt is long-term.
Note: For this exhibit, we assume that 100% of the cash is repatriated and 50% of it is spent on buybacks. For different buyback assumptions, please see the section on repatriation.

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