U.S. small-cap firms look to spend tax savings on tech, not jobs

Hennessy Advisors

10/10/2017 12:00

By David Randall 
    NEW YORK, Oct 10(Reuters) - A Texas-based chain of strip 
clubs would go on a buying spree. A growing technology company 
would move fewer jobs overseas. And a regional bank would boost 
its spending on cybersecurity. 
    These are some of the uses of the tax savings that small and 
medium-sized U.S. companies say they would pursue if the Trump 
administration and the Republican-controlled Congress slashed 
corporate taxes as promised.  
    Small companies pay the highest taxes and they would be the 
main beneficiaries of such a Trump windfall. Reuters contacted 
the 100 largest companies by market value in the benchmark 
Russell 2000 index of U.S. small and mid-cap stocks as well as 
another 50 in the Russell 2000 with no analyst coverage. None of 
the 17 companies that responded to Reuters queries mentioned 
boosting their headcount. 
    The administration has said the tax cuts would largely pay 
for themselves by spurring more investment and creating jobs. 
    But companies say they look to spend on technology that will 
allow them to improve productivity or make acquisitions rather 
than hire more workers. 
    "We want to be a company of the future, and technology is 
one of the key ingredients," said Keith Cargill, chief executive 
at Dallas-based Texas Capital Bankshares Inc  TCBI.O , a bank 
with a market value of $4.2 billion. The tax cut would be a 
"huge plus" for earnings, Cargill said, but with little impact 
on the bank's workforce. 
    The Russell 2000 companies tend to pay the highest effective 
tax rates now - an average of 31.9 percent, according to Thomson 
Reuters data - and would stand to gain the most if corporate 
taxes are cut to 20 percent from 35 percent as the Trump 
administration has proposed. (Graphic: http://bit.ly/2g7e5O9) 
  
    For large companies in the S&P 500, the average effective 
tax rate is 28 percent, a reflection of a greater share of 
overseas business and more leeway in reducing their tax rates. 
    While few companies would discuss any details in public 
before outlining them to their shareholders, executives, chief 
financial officers and treasures say they are already starting 
to formulate plans for a tax windfall even if they are not 
certain whether and in what form it will pass.  urn:newsml:reuters.com:*:nL2N1MH0I3  
    Neil Hennessy, the chief executive of Novato, 
California-based Hennessy Advisors Inc  HNNA.O , a mutual fund 
company, told Reuters he was in "acquisition mode" and would 
keep looking for targets in the event of a tax cut passing. 
     
    STRIP CLUBS AND SHARE BUYBACKS 
    One of the first firms to publicly discuss a potential tax 
windfall is RCI Hospitality Holdings Inc  RICK.O , a chain of 40 
strip clubs headquartered in Houston, Texas. Its chief executive 
Eric Scott Langan told analysts on Aug. 9 that a tax cut would 
allow him to buy more clubs and boost the share price, which he 
complained failed to reflect the firm's organic growth.  
    "I think that's going to change and I think that's when 
you're going to see the multiple expansion come into play," he 
said during an earnings call.  
   (Follow Trump's impact on energy, environment, healthcare, 
immigration and the economy at The Trump Effect 
www.reuters.com/trump-effect) 
    The tax cut would also affect companies which do not pay 
taxes now either because they are not yet profitable or are 
using past losses to offset their tax bills.     
    Paul Auvil, the chief financial officer at cybersecurity 
company Proofpoint Inc  PFPT.O , said that the $4 billion 
market-cap company expects to start paying taxes in 2021 when it 
no longer be able to offset past losses. 
    By then the corporate tax rate would need to sink at least 
below 27 percent, Auvil told Reuters. Otherwise Proofpoint would 
move its intellectual property to an offshore company in Europe, 
where corporate taxes are lower, which would mean hiring up to 
100 back office staff there, said.  
    "These are jobs that have every reason to be in the U.S. but 
it will require tax reform."   
    The prospects of a tax cut have helped push the iShares 
Russell 2000 ETF  IWM.P  up about 10 percent over the last six 
weeks, compared with a 3.7 percent gain in the fund which tracks 
S&P 500  .SPX . 
    If the tax package does pass, large companies will be more 
likely to buy back their own stock, while smaller firms will 
probably reinvest in their businesses, said Tom Forte, an 
analyst at New York based D.A. Davidson. 
    "These companies are going to take every incremental cost 
savings from a tax cut and invest it to keep up with the Amazons 
 AMZN.O  and Ubers," Forte said.      
    For instance, Forte expects EBay Inc  EBAY.O  to spend most 
of the possible windfall on increasing its stock buyback 
program. A smaller company like Yelp Inc  YELP.N  would probably 
invest in artificial intelligence technology to better harness 
its website's advertising potential, he said. 
    GrubHub Inc  GRUB.N , meanwhile, would spend more on its 
service that delivers from restaurants that do not have their 
own delivery staff, Forte said, while Groupon Inc  GRPN.O  would 
invest more in marketing and advertising. 
    Some smaller companies are also considering share buybacks 
rather any significant changes to their capital allocation. 
    Thomas Castellano, treasurer at drug delivery company 
Catalent Inc  CTLT.N , told Reuters that the $5.2 billion 
company would keep spending on maintaining its 35 locations 
around the globe and look for possible acquisitions. Any extra 
money would go to share buybacks and Catalent was unlikely to 
increase its hiring rate if a tax cut passes, Castellano said.  
    "We wouldn't be adding to our headcount because that would 
affect our margins at a time when we would otherwise see them 
improving."  
 
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Small-cap sectors ranked by median effective tax rate     http://bit.ly/2g7e5O9 
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 (Reporting by David Randall; Editing by Jennifer Ablan and 
Tomasz Janowski) 
 ((David.Randall@thomsonreuters.com; 646-223-6607; Reuters 
Messaging: david.randall.thomsonreuters.com@reuters.net)) 
 
Keywords: TRUMP EFFECT/SMALLCOMPANIES TAX