Wednesday, July 16, 2014

Are Corporate Inversions Hiding Disease?

Are Corporate Inversions Hiding Disease?

As one pharmaceutical company after another executes or at least contemplates a corporate inversion, most politicians and analysts are focused on the deficiencies of the corporate tax code.  For those who have been on vacation, an inversion is the acquisition by a US corporation of a foreign company, often located in Ireland.  The surviving entity is the foreign corporation, which magically confers foreign tax status on the combined entity.  In addition, the inverted corporation also achieves greater flexibility in dealing with cash that has been trapped overseas when the company was domiciled in the US. 

The reaction has been predictable.  Some commentators have called for Congress to cut the corporate tax rate or declare an amnesty for the repatriation of cash.  Others have called upon Congress to close the loophole in order to prevent companies from changing their legal structure in order to avoid the Internal Revenue Service.  In all likelihood, Democrats and Republicans will line up on opposite sides of the issue, and nothing will happen.  Wall Street analysts are excited about the prospects for higher after-tax earnings.

I think there’s a completely different message coming from the growing practice of inversions, and it is a reason for investors to be cautious.  While Wall Street analysts are excited about inversions, they are ignoring a more important signal.   The quality of earnings generated by inversions is low, and the move to invert may signal that these companies don’t have many strategies for building sustainable earnings growth.

Pharmaceutical companies are supposed to be growth companies.  Their highest value should be driven by revenue growth that comes from expanding applications of existing therapeutics and new drug discoveries.  If the revenue line of the income statement is slowing, then management usually focuses on improving gross margins by trying to cut costs.  This action is less valuable to investors because it only produces a one-time boost in profits.  As management moves further down the income statement and begins to tinker with research and development, investors are usually even less enamored of the resulting increase in profits.  If R&D is being cut, short-term profits are likely being generated at the expense of long-term gains.  In short, investors should be increasingly concerned about a company’s growth prospects as management’s focus drops further and further down the balance sheet.

So what should we make of the growing trend of inversions?  The tax code hasn’t changed appreciably in recent years.  The inversion has been possible for quite some time, and a few companies have taken advantage of it over the past several decades.  What has changed is the prospects to expand profits through top line growth. In my opinion, corporate executives are struggling to find adequate opportunities for organic growth.  As a result, they’ve turned to Wall Street bankers, lawyers, and accountants for a solution. 

The bankers, lawyers, and accountants are going to earn their fees.  The executives will earn their bonuses.  The event-driven and merger arbitrage hedge funds will generate short-term profits.  Congress will block anything President Obama proposes.  Long-term investors will, once again, have a bit of value spirited away.  While corporate inversions may be a healthy sign of financial creativity, they may be obscuring signs of disease within the very companies that take advantage of the strategy.

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