As they head into earnings season, drug and medical-device companies stand poised to take advantage of a one-time federal tax holiday that could help repair and bolster their balance sheets. Analysts expect big medical companies -- including Schering-Plough ( SGP) and Johnson & Johnson ( JNJ) -- to be among the most aggressive in exploiting this opportunity to soften the tax bite on profits from foreign subsidiaries, thanks to a law signed by President George W. Bush on Oct. 22. "Some of these companies have a huge piggy bank overseas," said Greg Kelly, a public policy analyst for Susquehanna Financial Group. "Until the law was passed, you couldn't use the overseas money in a domestic fashion unless you were willing to pay a big tax." The law lowers that tax rate to 5.25% from 35% for one year. Large medical companies "certainly have been keenly interested in this law," said David Lugg, a credit analyst for Standard & Poor's. "It's a tremendous opportunity." However, these companies -- and many others -- seeking to repatriate earnings from foreign subsidiaries don't really know what they can do with the tax holiday because the law remains shrouded in ambiguity. The law says the tax break can't be used for executive compensation, but almost everything else is on the table -- or at least subject to interpretation. Pay down debt? Definitely. Finance stock buybacks? Probably. Raise dividends? Likely. Finance mergers and acquisitions? Probably. Pay litigation expenses? Possibly. Bolster underfunded pensions? Maybe. The law is so filled with uncertainty that S&P, which wrote a report in mid-September while Congress was still debating repatriation, won't write an update until it gets a clearer signal from the Treasury Department. "We believe the Treasury Department will give companies fairly strong leeway," said Kelly of Susquehanna Financial. The Treasury Department is expected to issue guidelines this month.
Until then, CFOs probably will be telling analysts during the upcoming round of earnings conferences essentially the same thing they told them during the last round: "We're not sure." And analysts will be struggling with financial models because they won't know the companies' precise plans. "Quite likely, we'll be doing a lot of analysis on a case by case basis," Lugg said.
"I am concerned that pharmaceutical manufacturers may seek to exploit the 'financial stabilization' language to justify using repatriated funds to cover tort and product liability expenses," said Stark in a Nov. 30 letter. "I ask that Treasury promptly issue clarification that repatriated earnings cannot be used to fund tort and product liability obligations under the guise of financial stabilization." Stark said Merck and Wyeth might exploit the law to help defray costs of withdrawing Vioxx and the fen-phen diet pill cocktail, respectively. Wyeth has set aside $16.6 billion in reserves; Merck says it is too early to gauge the amount of reserves it will need. "If these pharmaceutical companies are permitted to use tax-preferred repatriated earnings to fund their legal liabilities, it would be an extraordinary benefit," Stark said. Analysts believe the law will be so attractive to some companies that they will borrow money so they can repatriate as much money as possible. "This is the case for some of the major pharmaceutical companies," said the Morgan Stanley report written by analysts Elmer Huh and Rebecca McCaughrin. Other health care companies -- medical devices, hospital supplies, mid-size drug companies -- also can be expected to repatriate all or some of their foreign earnings, they said. How companies will apply the law makes for some interesting financial speculation. For example, how does the law affect Johnson & Johnson's proposed takeover of Guidant ( GDT)? Standard & Poor's has speculated that J&J might use most of its overseas cash to finance all or part of the $10 billion-plus cash portion of the $23.9 billion deal. S&P kept its top AAA rating on J&J, saying it doubted the company would incur extra long-term debt. "J&J has significant overseas cash reserves," said a recent S&P report. By Sept. 30, J&J had cash and investments of more than $13 billion, most of it overseas, the ratings firm said.
The new law "could facilitate the repatriation of this cash for debt reduction," S&P said. "If not, Standard & Poor's still believes at least 70% of these funds could be available for debt reduction, offsetting as much as $9 billion of any new borrowings." The Morgan Stanley analysis of unremitted earnings shows that J&J had $12.3 billion for fiscal 2002 while Guidant had $1.5 billion. Despite the law's uncertainties, analysts are certain that the earnings repatriation portion of a law, called The American Jobs Creation Act of 2004, won't produce many jobs. "Few companies plan to use the repatriated earnings for hiring," says the Morgan Stanley report. Surveying its analysts, the firm found that "none of the respondents indicated that the companies under their coverage intended to use the repatriated earnings for hiring." That squares with Kelly's view of what companies will do. "Financial flexibility will lead to job creation over time," he said. "But you won't see immediate hiring by building new factories right away."