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This Mistake Destroys More Value Than the Government Ever Could

By Dan Ferris, editor, Extreme Value
Friday, November 16, 2012

A few weeks ago, I called Apple... 
I spoke to an investor relations person about the company's massive cash hoard. She confirmed Apple has $121.3 billion in cash and securities on its balance sheet... Of that amount, a "substantial portion" of the company's cash is "indefinitely reinvested" in accounts outside the U.S.
Specifically, $82.6 billion of Apple's total cash position is held in foreign accounts.  
The story is similar at other big-name blue chips... For years, companies like Microsoft, Cisco, and Johnson & Johnson have kept a large portion of their cash offshore. This strategy allows them to pay lower taxes on their earnings.
It sounds like a good idea. But it's not. A preoccupation with tax rates is hurting shareholders. Let me explain... 
At 35%, America has one of the highest corporate tax rates in the world.
This means companies are required, by law, to pay 35% of the income they make to the government. But corporations have found a legal workaround... Businesses that earn big profits in lower-tax countries leave that money overseas, so they pay lower corporate taxes.  
Apple, for example, paid a lower effective tax rate in its latest fiscal year of 25% – well below the U.S. corporate rate of 35%.
I realize most shareholders would like the companies they invest in to pay the lowest possible tax rate... That's why many investors don't care much about their companies' massive offshore cash holdings. But they should...  
Longtime DailyWealth readers know I'm an enthusiastic supporter of software giant Microsoft. I recognize it's one of the all-time-great creators of shareholder value... Microsoft has compounded shareholder wealth by an average of more than 25% per year since it went public. Few corporations can say the same.
So why is the stock of such a wonderful business trading at such a depressed market valuation? 
Right now, the S&P 500 is trading around 16 times earnings. Microsoft trades around 11 times earnings. It should trade at a premium to the market, not a discount. What's going on?  
According to the most recent data available, Microsoft has over $60 billion in cash, cash equivalents, and short-term investments. More than 90% of it is sitting idly in accounts outside the U.S. Microsoft would have to pay $19.4 billion in taxes if it were to bring that cash home to the U.S.
You may think shareholders will end up better off if the company doesn't essentially light $19 billion on fire. But Microsoft shareholders should fear bad capital allocation much more than they fear the taxman.  
The U.S. taxman won't destroy 100% of the dollars a company brings home. We can't say the same for companies themselves...  
I recently spoke with one of Microsoft's investor relations representatives about the $8.5 billion purchase of Luxembourg-based Skype in October 2011. She offered the Skype deal as evidence Microsoft uses offshore money to create shareholder value. Microsoft paid more than three times what eBay paid for Skype not too long ago. Is Skype three times closer to making a net profit? I sure hope so...
That's not the only bad acquisition management has made. In 2007, Microsoft bought out digital marketing and service provider aQuantive. The acquisition cost $6 billion and was recently written down to zero. The money is gone.  
Tell me... would you rather own 100% of aQuantive and Skype... or 65% of $14.5 billion? The aQuantive acquisition was essentially a 100% tax on the invested capital. The U.S. government, by contrast, charges just 35%. Who is the bigger threat to your money? 
Most people view taxes as bad and corporate mergers and acquisitions (M&A) activity as good. It's silly. It's like saying you'd rather lose your money gambling than have it stolen from you. It doesn't matter who ferried your cash away. It only matters that it's gone.  
Piling up cash to avoid paying taxes is a denial of reality. Corporate managers deny reality when they pretend tax efficiency is a priority. And shareholders deny reality when they let management get away with it.
There's really only one solution to the problem: return the excess capital sitting idly on the balance sheet to the owners of the company. Investors are starved for safe, growing income now more than ever.
Microsoft generated over $29 billion of free cash flow last year. It paid out $6.4 billion in cash dividends. It could have paid out triple that amount. Microsoft has enough cash to raise its dividend by 50% immediately. If it instituted a policy of paying out 60% of its free cash flow, I wouldn't be surprised to see shares rise 40%.
My point is simple: Tax efficiency is NOT more important than smart capital allocation. Shareholders should revolt against companies that think it makes sense to play tax games with shareholder money. They should insist the money be brought to the U.S. for distribution to shareholders via dividends or share repurchases.
Good investing, 
Dan Ferris

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Market Notes


Things are getting extreme again in the gold-stock sector...
This summer, gold stocks reached an "extreme" cheapness level when priced against physical gold. Gold had been advancing for 15 months, and gold stocks had been declining for 15 months. So, the ratio of gold stocks to physical gold reached an extreme level last seen during the 2008 credit crisis.
A solid rally followed the extreme cheapness reading. The big gold-stock fund rallied 20% in less than a month. After correcting from the rally, gold stocks reached the extreme level again. This was followed by a 34% rally in two months.
Below is a two-year chart that plots gold stocks (GDX) against gold (GLD). A sinking line represents gold stocks becoming cheaper relative to gold. Gold stocks have sold off badly in the past few weeks... which has taken them back down to the extreme levels of cheapness. Expect another rally soon...
– Brian Hunt

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