Obamanomics' Effect on Industrial Stocks

Winds of change are blowing through Washington, and their effects are likely to be felt throughout our industrial stock coverage universe in a big way. Specifically, two proposed changes in business law may prove to be quite nettlesome for any part of the nation's industrial complex that employs a significant amount of human labor or receives income from overseas subsidiaries.

Card Check
The Employee Free Choice Act (known as card check) was introduced in the U.S. Senate last week. If passed, there's a chance it could stanch what has been a steady decline in private-sector union membership over the past 30-plus years by making it much easier for organized labor to infiltrate nonunion shops and industries. Under current law, if a union wants to organize a nonunion shop it has to receive an affirmative vote from the majority of workers at that location through a secret vote that is taken if the employer deems it necessary (alternatively, the employer could waive the election and just recognize the union once it saw the majority would be in favor, but this rarely happens). If the majority votes in favor of organizing, the National Labor Relations Board certifies that union as labor's representative. Under the current law, the employer holds a fairly strong hand, as a secret vote reduces the effectiveness of intimidation tactics of organizers and also allows the company to campaign about the merits of remaining nonunion in the interim.

Card check would change all of this by doing away with the mandatory secret ballot test (it would be optional) for organizing. In its place, criteria stating that as soon as more than 50% of the workforce signs cards indicating they'd like to organize, that workforce is unionized. Further, if the newly organized union and the employer cannot agree on a collective bargaining agreement within 90 days, either party can request federal mediation, meaning the federal government would quickly be involved in setting that company's labor costs. Under this scenario it's not hard to imagine several instances where labor costs would be set at levels higher than if done so by the free market. Needless to say, the business lobby is up in arms over card check and is throwing significant resources toward defeating the bill.

It remains to be seen just how effective unions will be in intimidating workers into unionizing if the bill (or a mildly watered-down version) is passed, but we suspect the efforts to do so will be intense. Private-sector union membership has held steady between 7.5% and 8% of the private sector workforce for the four years ended in 2007, but has declined from over 30% in the early 1970s. Clearly, union power has been waning as pro-business, pro-growth policies gained prominence throughout the past several decades. It's very clear to us, however, that Obama wants to change this employer/employee dynamic to one in which labor holds a much stronger and likely more adversarial hand.

If the bill is passed in its current form, investors should brace themselves for companies incurring increased labor costs, less motivated workforces, and less flexibility to adapt to changing business conditions. As for specific companies, we'd expect the highly trained workforces of  Toyota's (TM),  Honda's (HMC), and  Nissan's (NSANY) Southern-state car plants to immediately be in the cross hairs of the United Auto Workers. After seeing the fate of the workers in Detroit, however, it may be a tough sell for the folks in these very productive plants. Also, we'd expect the nonunion drivers of  FedEx (FDX),  Con-Way , and  Old Dominion (ODFL) to be approached by the Teamsters.

Many of the nation's other manufacturers may also be at risk of stunting the significant progress made in lean manufacturing techniques over the past decade. Great strides have been made in worker productivity by implementing these manufacturing methods, enhancing margins as well as capital turnover ratios across the industrial space. For instance,  Parker Hannifin (PH) has enjoyed a 54% increase in its sales per employee over the past 10 years. Just over half of its 62,000 workers are located in the United States. If subjected to quotas outlining, say, minimum number of hours worked or rigid segregation of duties (as laid out in some union contracts), this trend is in jeopardy.

In short, the American workforce has made great strides in increasing its efficiency and competitiveness over a period in which union membership was in steady decline. We're not sure how that trajectory would change in a "card check" world, but we have a hard time seeing how manufacturing efficiency would be improved.

 

Overseas Income
Another proposed change that could impact industrial stocks is language within the 2010 proposed budget to increase taxes on overseas corporate income. The U.S. federal corporate tax rate currently stands at 35%, which is at the high end of global rates. To circumvent this, many of the industrial companies we cover employ assets (factories, service organizations, administrative facilities, and even corporate domiciles in some cases) in lower-tax jurisdictions. Under current law if a company sets up a factory in a lower-tax jurisdiction, it pays corporate tax at that country's rate and is able to defer paying the difference between that lower rate and the 35% statutory U.S. rate until it repatriates the earnings back to the States. Most companies choose to defer repatriating these profits indefinitely (or until a tax holiday is declared, such as when repatriated earnings were taxed at a one-time rate of 5.25% under the American Jobs Creation Act of 2004), and as a result enjoy materially lower taxes. Over the past several years, a large number of the industrial companies in our coverage universe have materially reduced their effective tax rates by locating in low-tax jurisdictions.

Although details are far from clear, some language in the Obama administration's budget proposal suggests this tax break for foreign income may be at risk. Within the president's message is language indicating the administration wants to "eliminate incentives for companies that ship jobs overseas," as well as an estimate that the budget would increase receipts by $210 billion over 10 years by "implementing international enforcement, reform, deferral, and other tax reform policies." Encouragingly for investors, there has recently been talk of lowering the U.S. statutory corporate rate in exchange for eliminating the "deferral" clause, indicating the administration may be open to some modification of what would be a very punitive change.

Investors can determine the tax benefits derived from foreign low-cost income simply by examining the tax note in the annual reports. A favorite of this analyst, the note lays out, among other useful information, exactly how much each company's effective taxes are decreased by operating in low-tax jurisdictions. To that end, we examined the tax notes of more than 160 industrial companies to determine which ones are most at risk if the deferral provision in the U.S. tax code were to be changed.

As one would expect, the group has benefited in aggregate, as these companies saved roughly $9 billion last year by operating a portion of their businesses overseas. The group's total effective tax liability was $37 billion on $126 billion of pretax income; it would have been $46 billion without the foreign tax reduction. The effective tax rate of the group, including state taxes averaging about 2% net of federal benefit, was about 29%; without the foreign tax benefit, it would have been roughly 37%.

As for individual companies, it's no surprise that the largest multinational companies were also the biggest beneficiaries of foreign tax deferrals. Last year  General Electric (GE) reduced its effective tax rate by 27 points (8 points excluding GECS income added to the parent) through foreign deferrals.  Eaton's (ETN) effective rate was lower by 19 points,  Tidewater's  by 18 points,  Tyco's  by 17 points,  Black & Decker's  by 16 points,  Kennametal's (KMT) by 14 points, and  Crown Holdings' (CCK) by 13 points. Eight industrial companies lowered their taxes by 11 to 12 points, 26 lowered their taxes between 5 and 10 points, and 37 lowered their tax rates by less than 4 points. If legislation is enacted to reduce the foreign income deferral, we'd expect these industrial companies to be impacted the most. In fact, in order to protect their low tax rates several companies that were domiciled in Bermuda, such as Tyco and  Ingersoll Rand (IR), have recently moved their domiciles to countries with stronger tax treaties with the U.S. (such as Switzerland).

On the other hand, companies operating mostly in the U.S. or mostly as exporters don't have much exposure to a change in this tax law. Many companies in aerospace and defense, such as  Boeing (BA),  Raytheon , and  Lockheed Martin (LMT) enjoy very little to no benefit from foreign income and have effective rates close to the statutory level. Logistics companies such as  United Parcel Services (UPS), Federal Express, and  Expeditors (EXPD), as well as truckers and domestic rail operators also have little exposure to increased taxes if the foreign tax deferral is revoked. Of the 160 companies in our survey, more than 70 currently enjoy little to no benefit from foreign income. Investors holding these stocks needn't worry too much about changes in foreign income deferral policies.

In summary, investors interested in industrial stocks need to be aware that the operating environment going forward may look significantly different than it does today. If either measure is passed in anything near its proposed form, intrinsic values may well be lower to varying degrees across the space. Specifically, those companies in which labor makes up a significant amount of total costs and those with significantly lower foreign taxes may be in for some tough sledding.