Repatriation of funds
He who laughs last...
When the back of the bear market was broken in 2002, the cause was liquidity. Whether that liquidity is a good thing or a bad thing has been debated in these pages and elsewhere. Regardless of your take on the matter, the undeniable fact is more cash makes the market go up.
Enter the American Jobs Creation Act of 2004 (AJCA), passed into law in October of last year. The law has several facets, the most interesting to me being the section concerning repatriation of foreign cash.
Multinational companies were not subject to U.S. taxes on foreign income provided they did not bring that income back into the U.S. As a result, many companies have large hoards of cash sitting in overseas bank accounts. They don't want to bring the cash back into the U.S. because of the 35% tax hit.
Under the AJCA, companies get a one-year window to bring these funds back at the effective tax rate of 5.25%. The IRS just released guidance on how they interpret the law, so conference calls over the last couple of weeks have featured commentary about how much money various companies have been racing to repatriate.
There are rules, however.
Companies are required to develop a specific plan to use the cash. The IRS guidelines emphasize specificity should be the rule rather than the exception in this plan. The plan must be approved by the CEO and by the Board of Directors of the company, placing it squarely within the realm of Sarbanes/Oxley governance.
The plan must be executed over a "reasonable" amount of time. The IRS regs spend some time talking about this and we presume tax attorneys will tell their clients 2-3 years tops, except for plant expansions and building of hard assets.
A smart person can see there are loopholes here. If a company is looking to spend $100M on dividends, they could just spend that $100M on something else and use the incoming repatriated cash to pay the dividend. The IRS notes the segregation of funds is not required. Furthermore, they note their judgment of proper spending of this cash doesn't necessarily factor in previously announced expenditures.
However, the IRS also noted that having a segregated account is the easiest way to verify different funds. They also note any company able to demonstrate funding above a previously announced budgetary level will more easily be able to defend their repatriation tax break. Therefore, expect all tax attorneys to recommend separate accounts and demonstrable additional spending. If the IRS comes back and disallows some of the repatriation break, not only will it cost you 30% of that cash, and EPS miss, and you've run yourself into Sarb/Ox problems, too.
The amount of cash varies by industry and by company. What is clear from preliminary announcements is the pharmaceutical industry will be one of the major beneficiaries of this law. For example, Pfizer (PFE) just announced they were bringing back $29 billion (with a 'B') this year. Most other large pharmaceutical companies have made similar announcements in the $8-15B range. According to one of my sources, it looks like pharma will bring back some $60-90B in repatriated cash.
That's a lotta dough to be spent.
Bears will say this will not matter much. It will be used to pay damage awards in lawsuits (theoretically "financial stabilization for the purpose of job creation or retention") or advertising. To the latter point, we say every single pharma company has indicated they will back off direct-to-consumer advertising because of the regulatory and legal climate. To the former, we say the company will be required to prove how the decision saved jobs. Since most already have money set aside for lawsuits, it will be hard to use this new cash for this purpose.
To our minds, the most likely use for these funds will be to replenish the pipelines of big pharma. I've written numerous times about this perfect storm of patent expirations, failed trials, and withdrawn drugs. It has absolutely gutted the pipelines of the big pharma companies to the extent that most have multi-billion dollar holes in their revenue beginning in 2005 and accelerating through 2008.
It is clear the acquisition of companies is allowable under the repatriation guidelines, especially in a situation where the acquiring company does not lay off appreciable amounts of workers. In other words, this is not cash for a merger-of-equals transaction but actual product and/or company acquisitions.
Oh yeah, and the acquisitions must be in cash and the cash spend needs to be front-loaded. It's [insert your favorite gift-giving holiday here] time for executives at biotech companies across America.
The bulk of this $60-90B, in our opinion, will flow into the biotech sector in dramatic fashion. Whole companies will be bought out for large premiums and product deals will be larger than perhaps many have expected. The deal flow may start slowly, but it will accelerate rapidly as the best companies and products begin to be taken out. I continue to harken back to the early 1990's action between agrichemical monoliths and the small, high-tech seed companies. The agrichemical companies had essentially stagnated and saw the high-tech seeds created by small seed companies as their salvation. One or two acquisitions later and it was an all-out feeding frenzy.
I Buzzed yesterday about the effect on big pharma of this repatriation of funds. I very firmly want to be in companies on the receiving end of this cash, but that doesn't mean I believe the pharma companies are shorts here. These are all-cash deals, so the typical arbitrage opportunity is non-existent. Furthermore, big pharma will be repairing the very thing I believe makes them a great short candidate - the holes in their pipelines. While there may be specific companies (laggards in the acquisition game) who might make good shorts, as a sector the long biotech/short pharma pairs trade is last year's trade.
In a prior article, I mentioned this buying spree was likely to be funded by the easy corporate bond market. In the last couple of days, Brian Reynolds has detailed the uncertainty in that area caused by General Motors (GM). This had me a little worried because a lack of funds could dampen the acquisition spree I've been predicting. As I noted before on the Buzz, it would suck if the biotech sector had all its ducks in a row only to have the water drained out of the pond by a suddenly bearish bond market.
This repatriation windfall makes the water supply to our little pond much more secure, making my thesis of outperformance by the biotech sector also more secure. I'm not going to say the sector can withstand a macro market firestorm, I'm just saying there is plenty of water (to continue the pond analogy) to douse most flames directed our way.
I don't know if this is 1H-2005 business or 2H-2005 business, but I can't imagine this effect will be minimal for the biotech sector in 2005.
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