Adam, it’s great to have you here, excited to be speaking with you today. So as Matt mentioned and I understand, you’re a financial analyst for a specialty finance division of a US bank.
Could you just tell us a little bit about what you do, what a day looks like for you?
Sure, Howard. it’s a pleasure to be here.
So we’re basically investors in high yield debt, but because we’re a commercial bank, we focus on buying the secured bank debt of junk bond companies or non-investment grade companies. We can’t really focus on investment grade companies because their debt doesn’t yield enough for us to make money.
So we’re sort of lenders, but we’re really more investors or asset managers in a market that’s called [the] broadly syndicated loan market. You in a normal times, even though these are loans and you wouldn’t find them on your Vanguard account to buy, there is an active secondary market for these assets and we can buy and sell them. So there’s a constant monitoring process that goes on.
So just to give you an example: Big sell side banks like JP Morgan and Bank of America, they lend giant chunks of money, they could do up to a billion dollars or a few billion dollar deal, and they didn’t want to carry all that debt on their balance sheet. So they sort of chop it up and form a syndicate, which is a group of lenders and they spread their risk out and we get to buy pieces of that loan and numerous other loans and have a diversified portfolio.
So that essentially sums up our day to day or the big picture of what we do, at least.
You guys are basically investing in potentially a piece of alone from a big bank. I guess they’re essentially taking a debt instrument, chopping it up, and then you guys are investing in some new debt instrument, a piece of the original debt that the big bang established. And you guys are, or I guess doing some analysis around that debt and trying to understand what you think is a good investment; what you think ultimately, I guess, be paid back and then also pay you guys interests.
Does that kind of summarize it?
Yes. So where we are, we’re putting these – they’re assets for us, they’re loans, but for us, they’re interest bearing assets. And we put them on our balance sheet. We have in the past, put them in funds called CLOs, which stands for collateralized loan obligations. Think about those mortgage securitizations, but these are corporate loans. And by the way, they didn’t have the same problems that the mortgage stuff did.
We’re even competing with insurance companies that buy this stuff and put it in their separate accounts or pension funds, other finance companies, and right now is quite the robust market. And there’s tons of money sloshing around because interest rates are very low because everybody’s looking to grab yield wherever they can know. [But] because these are high yield issuers. They’re not investment grade companies. So we have to do a lot of really intense analysis about the free cashflow, these companies and their ability to repay the debt
In terms of your role or just the role of a financial analyst in general in this space, is that what you really focus on is kind of analyzing these companies and understanding their business model and trying to make a prediction and, essentially, [verify] if the business is going to be successful and ultimately be able to repay their debt obligations that you guys are investing in?
That’s right. So formally they call me a quote unquote underwriter assessing the ability of the capacity is the word we use at the borrower can repay the debt. Other people throw around words like default risk or solvency. The loans we buy are also in the territory of what are known as cashflow loans. So their repayment directly hinges on the borrowed is free cash flow or metrics that show that their free cash flow is strong enough to warrant a refinancing when that time comes because the leverage multiples [for] a lot of these deals are very high.
Now it’s a robust market, just like the stock market’s up [so] our market’s up to. So these companies are able to put on more debt. Now you have to be able to assess their ability to refinance off, which is, you know, basically tied to the same understanding of the robustness of their cashflow.
That makes sense. And I guess when you’re thinking about cash flow and trying to understand these companies’ cash positions, what sort of reports or metrics or tools do you have in your toolbox to gauge company’s free cash flow might be, or might look like?
Sure. So generally there’s a primary market, which is the JP Morgans and the Bank of Americas of the world often call the “sell side banks”. These transactions where the investor – or the buy side, and they’re the sell side – they’re basically selling us debt. So the sell side bank or the big banks, JP Morgan or Bank of America, work with the borrower to provide marketing materials.
There’s usually a bank meeting with a presentation and it’s usually accompanied also by an offering memorandum, which is this big book that the sell side bank puts together on behalf of the borrower, which has all sorts of qualitative and quantitative information that help us assess the borrower. Think of the sell side banks as kind of the realtors, trying to sell you the asset. In this case, it’s a loan on behalf of the person, or the actual borrower.
So we usually get historical financial statements. There are often public companies, which is easy because they just have to direct you to the SEC website where you can pull down their [link: https://iono.fm/e/1083428, TFS PR 010: Annual Vs. Quarterly Provision] 10-Ks or annual public financials or their 10-Qs, which are their quarterly financials.
There’s also larger private companies, which often have pretty robust audited financials that we’ll require that’re akin to the disclosure and you’d get in the public filings. And then you can get down to smaller private companies, which the sell side bank will enlist. Usually one of the big accounting firms to do what’s called a Q of V or a quality of earnings report, which sort of mimics the information we would get in the financial statements of the larger companies. One of the big metrics that comes out of all of this is this thing called EBITDA or earnings before interest taxes, depreciation, and amortization among other things.
And there are deals that we won’t even do because we’re not particularly happy with the disclosure. And these sell side offerings also often include a projection or a forecast, which is typically an Excel model, which the bankers put together, the sell side bankers and the CFO or the treasurer. And they tell us how the company is going to do over the next five to seven years. A lot of the loans that we look at are these things called “term loan B loans,” where they’re not required to make amortization payments or very sizable ones until the very end of the loan.
So you’re have to be careful because these guys are borrowing money for seven years and you really want to understand their free cashflow and their solvency over a longer period of time.
So when you say that is it basically like a zero coupon type loan where you’re just paying kind of like a balloon payment at the end, or are they paying interest throughout. And then the principal is just all at the end?
And it’s close to that. It’s most commonly a one percent of the total balance of the loan is due each year. And then 93 or 94 percent at the end. Some people call them secured bonds now because the market is really somewhat argue overheated. It’s definitely an issuer’s market. You know there’s so much money sloshing around looking for yield.
So yes, they’re very borrower friendly structures and that’s part of it.
That’s helpful. I just want to emphasize one point you made, and then I do have a follow-up as well…
… But you mentioned looking at public companies’ financials, and then private companies’ financial financials info. We’ve spoken about them on this show before the differences between the 10-K and the 10-Q. And, you know, we’ve spoken a bit about private company requirements as well, but I just wanted to emphasize the fact that you mentioned large private companies do have similar requirements to public companies in terms of their financial statement filings, you know, issuing a quarterly or annual report and a big reason for that is folks like you and your company, and the fact that these companies issue debt, they need to have financials supporting what’s going on and being able to hand those to you investors and debt holders like your company and like the other ones you mentioned so that investors and debt holders have something to look at and something to understand the financial position of a company.
So that’s a big reason why private companies do have these type of financial statements that may not be as detailed as public companies to your point, but are necessary to have those audited financial statements for this type of reason. But that was just an aside.
At one point I did want to come back to is you mentioned a big part of this analysis you’re doing is kind of looking out to the future. And you mentioned that loan is not going to be repaid maybe for a number of years. You really need to ensure that the company is obviously in good health and is going to be successful years from now. And, you know, you said a part of the way you do this is looking in the past, right? Looking at their earnings and their history of earnings are, and then part of it is looking towards the future towards a projection, which in the tax world we’re very familiar with, especially on a quarterly basis, the tax folks have to use projections to kind of calculate tax expense.
But how do you verify that this projection is potentially accurate? How do you kind of do a sniff test to understand if you think this projection is where the company is actually… obviously it’s management putting forth this projection of this forecast, and they’re typically looking at best case scenario.
So how do you test that out?
So that’s an interesting question. And there are certainly deals. I’ve been doing this for many years. I won’t … say how much, I don’t want to age myself here. [Howard laughs.]
There are certainly deals that people get in trouble. And there are lawsuits because the projections that are provided turned out to be way off and people lose money. So there’s kind of an unwritten part of it, which is relationships – the agent banks, the Bank of Americas and the JP Morgans – have a certain reputation to uphold. A lot of these transactions involve these entities called financial sponsors. If they take private deals, they’re big private equity firms has maybe a more common word that’s used to describe them. It’s a trust factor. It’s doing transactions with sponsors that have expertise in certain industries. If it’s a private company, it’s a public company.
You can look back over time. I mean, certainly if it’s one of these specs that just, I’m not sure if even these newer transactions where these companies are bursting forth in these IPOs and they have limited disclosure requirements. Now your eyebrows definitely a raised, if it’s a chemical company that’s been around for 15 years and there’s SEC filings, we can look back and see.
But yeah, your comfort level with the financial reporting is definitely a huge part of it. And when we get into the tax stuff, you’ll see to the other part of your question, how we both look backwards and forwards to vet things. You know you can vet a lot of things in the forecast by understanding how to look at what’s happened in the past in historical financials reporting.
These loans are not mortgages. If you don’t pay the bank, doesn’t care because if their loan to value is okay, they just take your house. This is you’re relying on the company’s ability to generate cashflow over a long period of time. And you really need to understand that cashflow.
That is helpful, just kind of taking a step back, you get all this information. You’re starting to dissect the different pieces you have on the company, whether it’s a previous financial history, whether it’s looking at the forecast, whether it’s factoring in a relationship. And obviously like you said, the history of the company, the stature of the company, all kinds of plays in, but your ultimate goal, and kind of looking at all this, this to decide if your bank should buy a piece of the loan. Right? And so how exactly do you determine that? Like what factors you’re looking at specifically to determine what a company’s true cashflow position is based on kind of all the evidence at hand.
There’s a part of it, that’s qualitative, what industry they’re in. I mentioned that financial sponsor, you know, who the investors are. If it’s a newspaper company, we might put pens before we look at the book, because we have certain understandings of the sunsetting nature of that industry. If it’s a cybersecurity company or a software company, we would look further [as] those are growing industries. Other qualitative factors are their market share positioning, which is one thing that those presentations do. That’s the quality of stuff that you don’t get off of the raw financial numbers and the statements that the agent bank and the borrower will provide. So there’s all that qualitative stuff. Often we look at a lot of comps, comparable companies in the same industry, and you can find equity research on that stuff and get a larger, big picture of where the company’s industry is going and where they are in it.
And then getting to the numbers, which is a huge part of the story, we’ll break down the capital structure. A capital structure is basically the combination of debt and equity that the company is financing itself with a lot of times, these transactions or acquisitions or mergers, or as I said, uptake private where it will be a private company being acquired by a private equity concern. We look at how much debt there is relative to their cashflow and we’ll get into that in more detail, I think.
But I mentioned EBITDA previously, that’s a common industry number to get a general idea of their kind of raw cashflow on the sell side banks in the QB report, if it’s a smaller company, a common thing are these things called EBITDA adjustments or add backs. The company will say, “Hey, I just went through COVID-19. I spent $50 million cleaning the offices, and I’m not going to do that anymore.” So they’ll “add it back to EBITDA.”
So we assess those things: Are they non-recurring? The sell side bank is adding them back and all of their calculations, should we really be doing that? Then there are sort of recurring expenses that are commonly added back to EBITDA, like stock-based compensation because that’s not cash. But as we’ll talk about later, you have to take that into account when you’re calculating your tax. And I would say the most common ratios, financial ratios that we use are the amount of debt in the numerator relative to adjusted EBITDA. So that would be the earnings before interest, taxes, depreciation, and amortization, plus these adjustments, some of which we will kick out. And then in percentage terms, the amount of debt relative to the whole capital structure, some people call it a loan to value ratio or how much debt there is relative to what you think that the actual enterprise value; or if you sold the company tomorrow, how much money would you get the debt as a proportion?
It seems like your focus with a lot of these metrics is making sure that the company isn’t stuffed up too much debt that relative you obviously fund the company through debt, or you can fund the company through equity or a hybrid of the two, which is obviously the most common. And it seems like what you’re looking at with regards to a lot of these financial metrics at least is ensuring that company isn’t over leveraged that…
… you’re looking at an understanding that they don’t have too much debt in relation to their earnings. They don’t have too much [debt] in relation to their whole, a capital structure debt plus equity. Does that sum it up?
Yes, and it’s in context too. So a good barometer is – roughly speaking and it’ll vary by industry – is remember these are companies that are not investment-grade they’re riskier companies. So once you get into a ratio of four times debt to your annual adjusted EBITDA, that’s starting to get up there and that’s where we play. [But] it’ll depend on the industry. You’ll leverage a company that doesn’t have the requirements to make as much capital expenditure and its business. So it’s free cashflow is better go leverage them a lot more than otherwise.
Yes, you’re right. That’s the fundamental consideration. And then there are ratios and calculations and comparisons to make across industries to see where the company fits in.
That makes sense. And you mentioned comparables before, which obviously folks in the housing market, if they’re looking to buy a house, they’re familiar with that concept…
… and folks in the transfer pricing world for tax are quite familiar with that concept.
And one of the core tenants of transfer pricing is kind of looking at comparable transactions that similar companies and similar markets did for similar types of transactions to understand how to price a particular transaction. So that theme spans across the tax world and to the finance world that we’re into.
But I do want to circle back now getting more to tax specific items. When you look at all this information to understand the big picture of a company’s leverage and free cash flow, like we were talking about, where do come into play here, the tax provision in general, you mentioned EBITDA, which of course is carving out tax and carving out some of these other items and focusing more just on the core earnings of a business. But where does tax fit into this whole picture?
So I talked about leverage ratios. There’s this other ratio, fixed charge coverage ratio. It’s a commonly used overarching assessment of how much free cashflow the company has relative to its debt obligations.
So typically [for] this ratio, you’ll take the EBITDA and you’ll deduct how much capital expenditures the company has to make its investments in plants and equipment. And then you’ll compare that to their debt service, which is in the denominator. But in addition to ducting cap ex you’ll also deduct what you estimate to be the company’s cash taxes. So here’s where you really have to assess the amount of cash taxes. In addition to these other things, because these companies are a little bit on the edge, their solvency issue really needs to be addressed and understood over time and the “cash taxes” a big factor there. And understanding the tax provision, how much money they’re setting aside and all of the things that go into that becomes a key.
In addition to the leverage ratios and the qualitative factors getting into where tax comes into play, I think it’s helpful to look at this thing called the coverage ratio. So the fixed charge coverage ratio is the most commonly used credit metric.
So without getting too much into math, this ratio is a comparison of the free cashflow, which we’ll represent by: We’ll take the adjusted EBITDA, we deduct capital expenditures, and then we also deduct what we estimate to be the company’s annual cash tax burden or what they’re actually paying in taxes.
And then we compare that in the denominator to their debt service, which is essentially their interests, but also their amortization payments. Although, as we discussed earlier and nowadays, given the overheated market, there’s not much amortization to speak of often. So if this fixed charge coverage ratio is two times, it tells you the company has roughly speaking enough free cash flow after capital expenditures and tech and whatever their tax burden, they have some cushion relative to the amount of annual debt service that they have to make.
You mentioned looking at the ratio of free cash flow to debt. And it sounds like looking at free cashflow, you’re starting at this adjusted EBITDA and then you’re backing out [capital expenses], which is obviously a significant expense for the year. And then you’re also backing out cash tax, another significant – potentially – expense for the year but to truly understand what the actual cashflow of a company is, what’s their inflow is minus their outflows.
Of course, one of the key components of this is cash tax. Like you mentioned on this show in the past, we’ve spoken a little bit about the difference between cash tax and income tax expense on the financial statements. But cash taxes, of course, are the inflows and outflows of tax throughout the year, the actual cash dollars that accompany is shelling out in terms of their tax expense for the year.
And I guess in general, the issue I could see with you guys trying to discern cash taxes is, of course, they’re not necessarily disclosed in financial statements. A company doesn’t say, “I paid X amount of dollars in cash tax for the year.”
They do have a tax payable or receivable on their balance sheet, and you can look at the tax payable/receivable from last year compared to this year, you could look at their income tax position and understand what their current provision is, which is the current year expense, as opposed to the deferred expenses, which is kind of the tax expense of the future, but I’m just curious from a practical perspective, how do you guys look at cash tax and try to understand: What is the cash tax number for the year? How much in actual cash did these companies pay throughout the year in terms of income tax?
Sure. Getting into the specifics of what we actually do in calculating cash taxes: So as you said, there’s the “book taxes” or the income tax quote unquote expense from the P&L, and then there’s a cashflow statement.
The first thing we do is we take the tax expense and then we look for the changes in deferred tax assets and liabilities, and we can get into what those are. And there’s often you have to net the two to get a rough estimate of what the company’s “cash taxes” are, [or] how much they’re actually paying. So then we look at the footnote where they’ll discuss what those items are, whether they’re likely to recur. And we also look at their projection model, which we referenced earlier and see what the cash taxes are falling out of that model or that forecast.
Hopefully, it’s consistent with the past. A lot of times there’s an acquisition or two companies coming together in the past, [and] you have to look at it for both companies and you want to understand what the differences are because you want to understand how to project the actual cash being paid in taxes, going forward. And as I said before, over quite a long period of time, there’s a nitty gritty to what the most common sort of specific items you look for. But you take that netting – the tax expense and the net deferred taxes – you divide by their taxable income and you would get a tax rate, a quote unquote estimated effective tax rate. And when you look at the taxable income, you also want to take into account the potential one-time items. You’re looking at the past: assets sales, other things, sizable gains and losses that might be swaying that, and take those into consideration as well.
It sounds like when you guys are looking at tax expense for the year, you’re kind of carving out deferred tax, if I’m hearing you correctly. And that’s, you’re, you’re just trying to look at specifically for the current year, what is the tax liability look like? Carving out deferred tax, which is related to future activity, which you may not be sure when that tax expense or benefit is going to hit some point in the future. Is that right? Or are you kind of carving out over tax from the analysis?
I wouldn’t describe it as craving it out.
So here’s where the school meets the actual reality: So a lot of people refer to defer taxes as temporary differences.
So in other words, the most common way deferred tax liability arises is you’re depreciating an asset and you’re allowed, for tax purposes, to depreciate that asset more so in the beginning of its life versus the end, it’s called accelerated depreciation. So you have this book tax expense and your P&L, but then you have the separate set of taxes, which is calculated with this accelerated appreciation in mind. So you actually are paying a little less in taxes and you look to your cashflow statement to see how much that is, but the word temporary differences is sort of misleading because, if you have a large enough company, the temporary difference from one asset is rolling off and they’re putting other assets into their mix and they’re creating new temporary differences and there’s sort of a rolling benefit from this accelerated depreciation impact.
You don’t necessarily carve it out. You actually would often reduce your tax expense by the deferred tax liability benefit that you can pluck often from a good cashflow statement disclosure, and then your effective tax rate, in the US it’s 21 percent, [but] it might be 17 or 18 percent because of the impact of this particular very common tax benefit that I’m describing. And you would actually apply that going forward. Their tax rate wouldn’t be 21 percent, it would be 17 or 18 percent in determining their actual cash taxes paid.
When you talk about the effect of tax rate, obviously there’s an effective tax rate that companies disclose on their financial statements, which is essentially calculated as total tax expense, divided by pre-tax book income, accounting income before income tax. But it sounds like when you guys are looking at the effective tax rate, you’re looking at it potentially compared to taxable incomes, are you taking total of tax expense? Like current tax plus deferred tax, as in total tax expense, divided by taxable income to get to your version of the effective tax rate?
That’s a succinct way of saying what I just tried to say. [Laughs.]
So just for our listeners, so basically the kind of classic version of the effective tax rate that you’ll see on a financial savings or your ear it’s tax specific folks talking about is you have your current tax, which is just your tax expense for the year. You have your deferred tax, which is your future tax expense, which as Adam alluded to, driven by a couple of different ways, one of them is, is temporary differences, differences between book treatment and tax treatment. That’s going to reverse that at some point in the future, it’s temporary in nature.
You could also add net operating losses and credits and things like that, driving deferred tax expense. But basically you’re taking current plus deferred getting to a total tax expense and dividing it by your pre-tax book income, and that’s what most tax professionals are familiar when it comes to effective tax rate.
But here you guys are maybe taking into account that classic effective tax rate that goes on financial statements, but you’re also kind of building a separate effective tax rate where you’re looking at that total tax expense versus taxable income, which just kind of gives you a little bit of a different slice, a little bit of a different picture of what that other type of effective tax rate means. Another way to look at a company’s tax position and understand how significant or insignificant their tax liability is it. Does that summarize it?
And we didn’t go through deferred tax assets. You referenced those which are – as opposed to deferred tax liabilities, which are delaying the taxes until later – deferred tax assets or potential anything that gives a rise to potential future credit. Yes, but you’re fundamentally correct. Yes: In the way that we did the calculation and look at it.
That makes sense. And then, you know, I’m just curious when you talked about the types of companies that you guys are looking into, sounds to me like these companies [are] generally struggling at least to a certain degree. So I’m just curious if you find that a lot of companies are in loss positions and if they maybe don’t have as significant of cash taxes, as many other companies would?
That’s a good question.
So a lot of the companies we look at, they’re not necessarily struggling. They’re just being levered up. There’s a lot of debt being put on them. They might be very successful companies and they’re often companies which are sort of using leverage and maybe paying dividends their investors, as opposed to relying on growth and the funding themselves with equity.
But we certainly look at our investments on an ongoing basis and some of the companies do get into trouble. Some of them always do because of the nature of the business. And it’s true that generally speaking, obviously as your taxable income heads to zero, so do your taxes, but that’s something that we have to take into account when we’re projecting things out too, because things are pretty close to the edge often.
But yes, there are companies with losses who aren’t paying cash taxes in certain periods. It’s certainly arises.
I guess, if you have a company that is in a loss position and that w we’ve spoken about valuation allowances in the past, on the podcast, but let’s just assume that they expect to get out of that loss position at some point in the future and they don’t have evaluation allowance. So they would have some kind of tax benefit rolling through.
Would you take into account that tax benefit if you’re dealing with the tax benefit, would you just kind of treat it the same way as the tax expense?
Sure. So I think that you’re essentially referring to are NOLs or net operating losses, which are common in our space. They might be carrying them into their forecast because of whatever’s going on with one or more of the companies involved in the transaction, if there’s a merger or an acquisition. And those are big to understand because they’re chunky and they roll off eventually. And as I said, [for] these term loan B loans the convention has a seven year maturity.
Understanding the size of those and when they’re going away is a big factor in understanding a company’s free cash flow over time, certainly. And if they had two companies coming together and you’ve done your rough calculation that we mentioned before about deferred taxes and netting it against the tax expense, and if you do that over a few years and you get jumpy inconsistent results, there’s probably NOLs or other items in there that you want to understand and you have to discuss it with the company and pull them out and get a consistent idea of what the actual effect of tax rate is.
You kind of covered a bit of the difference between total tax expense and cash tax. And we spoke a little bit about this, but we talked about different tax liabilities a bit, we talked about deferred tax assets for DTLs. You mentioned depreciation being a very common one where tax has accelerated depreciation books as a little bit slower depreciation. And, you know, you get that tax benefit upfront and then you can pay for it on the back end a little bit later, kind of creating that DTL. And then on the DTA side, you could have items like NOLs or credits where you get a future tax benefit on the carry forward of these kinds of items. But what other kinds of factors differences between maybe accounting and tax are you looking at to kind of understand a company’s tax position?
Sure. So those are the big ones. There are others. Certainly in mergers and acquisitions and asset purchases, there’s a stepped up value of assets that the fair market value, which results in higher depreciation and amortization for tax purposes. That’s a common one. There are foreign earnings, which are when global companies bring money back from overseas, they incur lumpy or sort of non-recurring tax bills.
If you really want to see that and look into the public disclosure of any big company, and you’ll see a reconciliation of their statutory to effective tax rate, and you’ll see the impact of that. There are tax credits, R&D tax credits…
R&D tax credits are often recurring items, particularly for biotech or technology companies, but they can be a little bit erratic depending on the company’s R&D expense trend.
And another big one out there that is actually fairly controversial is the whole idea of share-based compensation. So this arises with public companies because these companies get to deduct from their taxes, the value of stock options when they’re issued. They usually value them in a certain way, but then if the company’s stock price shoots up, there’s there’s big tax benefits created based on the difference between that value and the value when they actually exercise the options. And you’ll often see the cash impact of that, believe it or not. In the cashflow statement and the financing section, there’s this thing often called the excess tax benefits from stock options and that can be the difference in hundreds of basis points or percentage points, two, three, four, or five or more percent in a company’s taxes that they’re paying.
We don’t come across that as much. It’s more of a thing for public companies with growing share prices, but it’s a huge factor.
I think that’s a great summary and you honestly covered a lot of the key tax calculations that tax practitioners focus on when they’re looking at a provision and then just in general throughout the year.
I just wanted to circle back to, we were talking about kind of a time period that you’re looking at originally on these loans, and it’s a bit of a longer time period. Obviously, we talked about seven years being some of the industry standard on the term of lent that the loans are paid off, but you have the past results that you’re looking at these items for. And then we’ll go through a little bit, the ones you talked to in a little bit more detail momentarily, but then you also kind of have to project some of these out in the future, which I imagine is quite difficult for things like stock comp, potential M&A coming down the pike.
You know, these are sort of more one-time items. The tax world, we were kind of described stock comp, at least as this sort of screed item, an item that is difficult to be forecasted. It’s more of a one-time item. That’s not recurring in nature. I’m sorry, I imagine that adds to kind of the complexity and the difficulty of what you’re doing here, but I just want to circle back to a couple of the items you mentioned. Cause I just think they’re so important when it comes to tax provisions as a whole. And obviously they’re very material, especially, you’re looking at them and assessing a company’s cash tax and an overall tax for good reason. You mentioned M&A and an asset purchase specifically how tax, when they acquire the assets of a company, whether that’s through a straight asset purchase or something called a 338 (h) (10), where they acquire the stock and elect to treat it as an asset to you, tax gets a step up of asset basis to fair market value, which could be very material and result in a significant depreciation amortization of the assets while books is, is just carrying over the value.
And this is kind of a really important difference between tax and books when it comes to an asset acquisition. And that takes a lot of work from a practitioner perspective to come up with what’s the deferred tax assets and liabilities as a result of that? How do you treat the step up? There’s a portion going that you have to account for through goodwill rather than deferred tax assets and liabilities. So that’s just practically a really important aspect and obviously really material one when it comes to your tax provision, you mentioned foreign earnings, calculating a foreign rate differential. The difference between the US tax rate and foreign rate and carving out how your income is getting taxed throughout the world, what tax rate, if you’re bringing money back into the U S how is that being taxed. Tax reform kind of change that. Now, you can bring certain cash back tax-free because it was previously taxed, but in the past, that looked a lot different.
You mentioned tax credits, which of course we have an R&D credit podcast focused on the R& D tax credit, but R&D credit is a huge one there’s foreign tax credits and other credits as well, which could be really material.
And then you mentioned stock-based comp. We had a couple of episodes where we really focused on stock-based comp. This is a hugely material and the tax treatment book treatment are really disparate in this area. Where books, you mentioned is creating some expense throughout the life of an option a little bit more evenly; while tax, you get to kind of take the full expense when it’s exercise and it’s typically a much higher expense if the company’s doing well, than the book and it results in this excess tax benefit.
And this hybrid of the stock comp results in a partial deferred tax impact, then also a partial effective tax rate impact for that excess tax benefit.
So we kind of dove into stock comp in a lot more detail on a previous episode, but I just wanted to mention the importance of all these factors that you mentioned, whether it’s from your perspective in analyzing a company and analyzing his tax position, or from a practitioner perspective, looking at these items. These are some of the key items that folks have to focus on when they’re doing a provision, so I just wanted to emphasize that.
And I just want to take a step back. We spoke a little bit about effective tax rate. We spoke about cash taxes, but in terms of the effective tax rate, how do you guys look at that? Are you just trusting the effective tax rate you see on a financial statement, you mentioned you look at the effective tax rate in a couple of different ways. One is kind of the classical the tax rate you see in a financial statement. Another one is the one you guys kind of come up with comparing it to taxable income, total tax expense. But how do you kind of look at that, does a company provide that to you? Are you calculating on your own? Are you plucking it from a financial statement?
Sure. So the materials that we get from the borrowers vary greatly. And I would say increasingly in this market where there’s so much demand for we call it paper or loans as assets, the level of disclosure sometimes doesn’t have to be that great to still sell the paper to investors. So a lot of the forecast models, most of them will have a good schedule arriving at the company’s taxable income, but often don’t have just sort of a cashflow summary and in there will be the cash they’re paying for taxes. And you certainly will do your basic division and see what that implied effective tax rate is over time.
And if it jumps around or if it’s successively low or high or varies widely from the statutory tax rate – which can get a little confusing in and of itself If you have a company with significant overseas operations writing together different statutory tax rates – but that’s where you have to put on your diligence hat and ask questions, or you go through the historical statements in the ways that we’ve gone through and see if you can discern stuff for yourself.
So I think that’s the overarching process. For the smaller companies, often actually there’s a very detailed schedule arriving at what their effective tax rate was and is going to be. And for public companies, there’s a lot of investigation you have to do on your own by looking in the SEC filings and building things out.
From that perspective, when we’re thinking about an effective tax rate, we see one thing that I know tax professionals focus on inherently is giving a trend analysis, but understanding how the effect of tax rates trending over time. And I would imagine that’s especially important for you because you have your past results, but then you’re also trying to look out to the future and understand where the company is going in the future.
So how do you think about the trends of a company and just specifically focusing on tax for now, how do you look at the effective tax rate from a trend analysis perspective, if it’s trending up down, flat, and then projecting it out in the future?
Sure. So it’s an interesting question.
So there are factors where if I’m looking at the company’s gross margin, for example, and if it’s headed straight down, in and of itself that begs eyebrow-raising questions about the company’s liability. So the tax rate is a little different than effective tax rates are inherently idiosyncratic. They may be inconsistent, not because there’s something fishy going on, or because it tells you that the company is in trouble, but just because there are these items that we’ve gone through – NOLs, step-ups, and asset bases, etc. – that are driving this idiosyncratic result.
So at the end of the day, you should be able to back out all of the material items like the NOLs and the non-recurring items, and get to a relatively consistent tax rate. Of course, if you go back far enough – in the US, they recently lowered the statutory tax rate, and you have to take history into account also.
But I would say if the tax rate jumps around, you should be able to understand why, and if you can’t, then that might lead to other questions about the people preparing the financials and maybe other questions about who they are.
And I don’t want to say that they’re hiding something because that’s rare, but it’s certainly a possibility.
The point about trying to identify extraordinary items is key. And that’s a big part of what the tax footnote is about. As you could look at the rate reconciliation, you could see what material items are moving the effect of tax rate. You can look at the deferred tax asset liability and asset summary and see how did my DTAs or details change over time. Is there a huge NOL driving the DTA up? Is there something else changing my deferred tax asset reliability position significantly in the current year?
So that’s using the tax footnote as a tool to understand – are there any extraordinary items, is that why the effective tax rate is maybe moving the way it is, or is it relatively stable? – I think is a good point.
One point you mentioned with regard to changing tax rates in the US: Obviously in 2017, we had to rate decrease from a corporate rate of 35 percent to 21 percent now. And we may be looking potentially this year, maybe next year, at now a rate increase going the other direction from 21 percent up to rigid. It was 28 percent. Maybe it ends up being 25 percent or wherever we potentially land, if something does get passed through Congress.
And obviously other countries are constantly changing their rates. The UK is fluctuating their tax rate pretty often and in other countries as well. How do you take into account kind of statutory changes into your models and into your analysis? Let’s just say in the US for example, now that the tax rate is potentially going up in the future, would that make it maybe harder to potentially invest in certain companies’ debt instruments, given that the tax liability is inherently going to increase in the future? And they’re going to have more cash expense, which is obviously going to drive down there for each cash flow, etc. Does this play into your analysis as well?
We definitely take the changes and statutory tax rates into account, as well as the difference between statutory tax rates in different regions, particularly if we have a global company that has operations in different countries.
So it’s definitely a factor. That comes down to knowing what those percentages are and how they’ve changed and taking it into account when you’re looking at the forecast and building your own forecast.
And certainly if you have companies that are tight on their fixed charge coverage – is the ratio I referenced earlier – or just tight on the amount of cashflow they have relative to their debt service. If their taxes are going to be higher in the future, it’s definitely a factor. And it’s one of the reasons why you want to have some cushion as you do [with] loans today, because it’s always a possibility.
And the last thing I would say about that is looking back, I know when they decreased the statutory tax rate in the US, it led to all sorts of one-time idiosyncratic items. There was, I think, a benefit to repatriating money around that time, which led to very jumpy, actual tax rates thing – how you would have to back out to project it going forward.
Where you’re alluding to there, 2017 is that Section 965 transition tax that the US was essentially changing from the paradigm before – where you get taxed on your foreign earnings in the US when you repatriate the money – to essentially saying you have to pay the piper today, even on those foreign earnings that you stashed abroad but at a lower rate. And then the goal was to kind of bring back some cash to the US once you kind of paid that tax at that lower rate, that transition tax.
So it’s a great point that there’s all these different factors to take into account, even when there’s a legislative change. It’s not just as simple as the rate and obviously [with] the Biden tax plan coming down the pike, it’s not just the rate changing there’s other factors there’s GILTI. There is potentially a repeal of FIDII. There is potentially a changing beat into this shield paradigm that we’ve talked a little bit about in the past. There’s also kind of international tax reform brewing as well with the BEPS 2.0 initiative.
So how does this whole stew of different regulatory changes result in an easily understandable change for a company? And then it’s probably very difficult to do that analysis until the law is actually written down in pen.
It’s interesting to learn about the fact that the tax provision and cash tax and other tax calculations are used in this whole other world. On this podcast, we haven’t spoken about this much, but it just shows the breadth of the way tax expense is kind of looked at in the investment world and the importance of it when it comes to financial statements, the financial health of a company. So really appreciate the context you shared and all the wisdom, Adam. So thanks for being here really enjoyed it.