U.S. tax cut to deliver corporate earnings gift

NEW YORK (Reuters) - The massive Republican tax overhaul working its way to President Donald Trump’s desk is making bulls on Wall Street a little more bullish.

The U.S. Capitol building is lit at dusk ahead of planned votes on tax reform in Washington, U.S., December 18, 2017. REUTERS/Joshua Roberts

Wall Street strategists are revising their 2018 earnings forecasts sharply higher because of the tax cuts, though the jury is out on whether that positive effect will endure much beyond next year.

The tax bill will cut the corporate tax rate to 21 percent from 35 percent beginning Jan. 1 and is expected to be the single biggest positive factor for earnings in 2018.

The Republican-controlled House of Representatives passed the tax package on Tuesday afternoon, but the move hit a last-minute snag, requiring another vote on Wednesday. A Senate vote was still awaited.

Although there is a wide range of profit estimates for 2018, the expected tax plan benefit has strategists now calling for double-digit profit gains in 2018 over 2017, compared with their forecasts for mid-single-digit gains without the tax cuts.

“This is going to drive the earnings numbers. (Tax) is going to overwhelm everything,” said Credit Suisse Group U.S. Equity Strategist Jonathan Golub, who was waiting for the bill’s passage to adjust his own earnings estimates.

With the U.S. and world economies expanding, consumer demand strong and interest rates low, corporate profits were expected to be healthy next year. The tax law will give them an added jolt of adrenaline.

Many strategists estimate the cut in corporate tax could deliver an extra boost to earnings next year of between about 7 percent to more than 10 percent. Some of the forecasts were based on a previous version of the legislation calling for a tax cut to 20 percent.

In one of the most recent projections, UBS on Friday said it saw a potential 9.1-percent boost to S&P earnings per share because of the tax plan.

It is unclear how great the lasting positive impact will be.

“The retention of this benefit is unclear,” said Savita Subramanian, Bank of America-Merrill Lynch’s head of U.S. equity and quantitative strategy, who forecasts the plan could add $19, or about 14 percent, to S&P 500 earnings including potential paybacks from repatriation.

But the net recurring benefit is likely to be closer to $11, or 8 percent, she said. Subramanian, in a presentation earlier this month, said companies may look to use the benefit for short-term lifts. For example, retailers, which have been suffering from competition from Amazon AMZN.O, may want to pass the benefit on with bigger sales and more promotions.

“You have to wonder how much of that benefit you’re going to really see float to the bottom line on a longer-term basis,” Subramanian said.

The boost to profits goes a long way to justify some of the rapid rise in stock valuations since Donald Trump’s election as president a year ago. Stronger earnings mean less stretched price-to-earnings ratios. Investors are paying about $18.45 for every $1 in expected earnings over the next 12 months, the most since 2002.

“Earnings may go up, but a lot of the benefit is already in the market,” Golub said.

The S&P 500 .SPX has gained about 5 percent since mid-November when the House passed its tax overhaul bill and is up about 20 percent year-to-date. Stocks drifted lower following the House vote Tuesday.

Golub and others said after the initial boost to forecasts, the profit numbers could still drift higher in the months ahead as companies adjust their plans.

“We’ll get a big jump in ‘18, but the ripple effect of the tax bill could be the big surprise in the second half of ‘18,” said Bucky Hellwig, senior vice president at BB&T Wealth Management in Birmingham, Alabama.

“The tax cuts... will give companies a lot more flexibility to do dividend increases, buybacks and hiring, and that’s what’s difficult to get a handle on,” Hellwig said.

Companies already are beginning to cite the tax cuts in forecasts. After the bell on Tuesday, FedEx Corp FDX.N said if the tax package becomes law, its earnings per share for fiscal 2018 could increase.

Reporting by Caroline Valetkevitch; Editing by Nick Zieminski