Corporate Earnings and Taxes - What's the Connection?

One of the more interesting aspects of this earnings season has been the number of companies reporting lower than expected taxes.

I closely follow the quarterly earnings announcements of 40-50 companies. Usually, maybe four or five companies - about 10% - will report a lower than expected tax expense. Maybe.

So far, 36 companies I watch have reported. Of those 36, taxes have come in below expectations for 14 companies, or nearly 40% of the sample, which by far, is the largest percentage since I explicitly started tracking my group five years ago.

Those 14 companies are:

CA Inc. (CA)

CVS Corp. (CVS)

Chevron Corp. (CVX)

Disney (DIS)

Eastman Kodak Co. (EK)

General Electric (GE)

InterContinentalExchange, Inc. (ICE)

Kraft Foods Inc. (KFT)

3M Co. (MMM)

Altria Group Inc. (MO)

Merck & Co. (MRK)

Procter & Gamble (PG)

Schlumberger Ltd. (SLB)

Zimmer Holdings Inc. (ZMH)

For a few companies, such as Disney, the difference between actual and expected taxes has been small. However, for others, such as Merck, the gap between reported and expected has been large. Several companies would not have made their estimate without the tax surprise.

Frankly, I am not sure exactly why so many companies are reporting a lower tax expense. Was there a tax law that expired at year end of which I am unaware?

There can be a number of reasons. My guess, though, is that profits being reported to the government for tax purposes are lower than being reported to the market, which would be consistent with an economic slowdown. Companies will dip into reserves to pad reported numbers so earnings look better to the market. When paying taxes to the government, however, there is no incentive for corporations to pad numbers.

To illustrate, corporate profits declined $20.5 billion in the third quarter. The decline in earnings was not due solely to charge-offs arising from the subprime debacle in the financial sector. Nonfinancial companies reported a decline of $14.4 billion.

And this was in a quarter when GDP rose 4.9%! If profits declined in a quarter with such robust growth, what do you think profits did in the most recent quarter, where the advance GDP was a mere 0.6%?

Some cheerleaders on Bubblevision...

...have been exasperatingly pushing investors to buy the market because, they say, the market is cheap, and earnings are expected to grow 20%-30% in the third and fourth quarters of this year.

I am betting investors taking this advice will be greatly disappointed as corporate profits are not going to come in anywhere near these expectations.

Comments

[echotoall]

each one of those companies are exposed to the global economy (except for CVS, and not sure about ZMH). Money made aboard i don't think subject to US tax rates, and if this quarter more money was made abroad then less of that rev would be subject to US tax rates. Could this be a more realistic explanation? Just a thought.

[Thinkingahead]

echotoall has a point. And tax rates bounce around in other countries like they do here. But your point is good too, if you can point to specifics. I follow a couple of these names and don't remember write-ups mentioned on the Q4 calls.