Loan borrowers warn U.S. tax policy may hit future earnings

By Kristen Haunss and Jonathan Schwarzberg, Reuters

Issuers of U.S. leveraged loans, including sensors supplier MTS Systems and department store retailer JC Penney, are warning investors that a provision in the U.S. tax-reform bills may weaken their future results.

Indebted “junk” issuers that rely on the $954 billion U.S. leveraged-loan market are keeping a close eye on Washington and efforts to overhaul the U.S. tax code that could cut the corporate tax rate to 20% from 35%.

These companies are focusing more, however, on a specific proposal to change interest deductions that may eat into their bottom line.

“Diminished interest deductibility, which is more punitive to highly leveraged companies, is likely to have negative implications for low-rated speculative-grade companies and could outweigh the benefits of a lower corporate tax rate,” Christina Padgett, a senior vice president at Moody’s, said in a statement.

Under the current structure, a company that is taxed at 35% can offset interest expenses with little to no limitations on bank debt, according to Gerald Whelan, a private equity tax principal at EY.

The U.S. House of Representatives and the Senate bills both put 30% limits on interest deductions. The House calculated that figure using EBITDA, while the Senate proposal uses a more restrictive EBIT calculation, he said.

It is unclear what provision the final bill will include.

Borrowers with the lowest credit ratings of CCC or lower will be most affected by the changes to interest deductibility, according to Matthew Mish, head of U.S. credit strategy at UBS.

If the final bill uses the Senate’s interest calculation, some companies could become distressed, which will also be exacerbated by higher interest expenses as the Federal Reserve moves to raise interest rates, he said. UBS expects a rate hike this month and two more in 2018.

Under the Senate proposal, $40 billion of the $75 billion of interest paid by high-yield companies will now be taxed, according to Bank of America Merrill Lynch data.

PE firms may need to contribute more equity to leveraged buyouts due to the bill, and more financings may be structured with preferred equity, Mish said.

Not all companies will feel the strain and other parts of the bill may offset the deduction loss as corporation tax falls.

“Even though limitations on interest expense is potentially adverse, free-cash flow should go up because the corporate rate has dropped by 15 points,” EY’s Whelan said. “It’s prudent for companies to flag the issue and work through interest limitations, but private equity buyers are not just looking at the provision in isolation.”

MTS, which repriced a $457 million term loan in July, warned in November about the potentially negative impact that the tax bill could have on its bottom line.

“Developments in tax policy, such as the disallowance of tax deductions for interest paid on outstanding indebtedness, could have a material adverse effect on our results of operations and liquidity,” MTS said in a regulatory filing.

Retailer Floor & Decor, which repriced a $152.5 million term loan last month, said the results of the 2016 elections and congressional reform proposals have “introduced greater uncertainty with respect to the deductibility of net interest expense,” a Nov. 16 regulatory filing says.

Developments in tax policy or trade relations, it said, may have a material adverse effect on its business, results of operations and liquidity.

Brian Ross, MTS chief financial officer, could not be reached for comment. Floor & Decor spokespeople did not return calls or e-mails.

JC Penney also warned that “developments in tax policy, such as the disallowance of tax deductions for interest paid on outstanding indebtedness, could have a material adverse effect” on its operational results and liquidity, according to a Nov. 29 regulatory filing for its third-quarter earnings. The company also included the same language in a regulatory filing for its second quarter results.

A JC Penney spokesperson said he could not speculate on how the tax proposals could affect the company’s tax deductions and declined to comment further.

For now, highly leveraged companies must wait for the final bill.

“There is some credence to the number of statements companies are making [about the impact] on liquidity and profits, but I don’t think it will be a death blow to high-yield by any stretch,” Mish said.

Action Item: Christina Padgett’s page at Moody’s: www.moodys.com/page/analystresearch.aspx?bn=Christina+Padgett&bns=21000385

Sen. Lisa Murkowski (R-Arkansas) speaks to reporters outside the Senate chamber during debate over the Republican tax-reform plan in Washington on Dec. 1, 2017. Photo courtesy Reuters/James Lawler Duggan