Is tax reform good or bad for medical device companies?


Capitol Hill Congress medical device tax reform

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Medical device companies and others in the healthcare sector stand to benefit from the tax reform Congress passed at the end of 2017, but the picture isn’t entirely rosy, according to a new report from S&P Global Ratings.

In many ways, the report offers a corrective to the bullish statements coming from corporate CEOs such as Johnson & Johnson’s Alex Gorsky, who recently told CNBC that J&J will repatriate $16 billion in cash thanks to the new law.

“I think the fact that we now actually have a competitive tax rate, that we’ve got a construct in place to repatriate earnings and cash from overseas is going to give us much more flexibility and make us more competitive,” Gorsky told CNBC in an interview.

Here’s how the S&P report, published on Jan. 2, broke down the situation – along with companies that especially stand to benefit:

1. Corporate tax rate cut: What tax cut?

One of the top business-friendly measures of the tax reform involved cutting the U.S. corporate tax rate this year to 21% from a previous 35%. But many large medical device companies already have a low effective tax rate because they’re doing business around the world, according to S&P.

An exception to the rule is Owens & Minor (NYSE: OMI), which had a 41.6% three-year average effective tax rate.

2. Capital expenditures deduction benefit is limited – and temporary

Companies with qualified capital expenditures such as purchasing new equipment get an accelerated depreciation (100% in the first year for tax calculations). But considering the year one depreciation was previously 50% under a much higher corporate tax rate, the benefit is more modest than one might first suppose, S&P reports. Plus, the provision starts tapering off in 2022.

In the medical device industry, companies with high equipment expenditures include Baxter (NYSE: BAX). The Deerfield, Ill.–based company – with its focus on products to treat kidney disease, immune disorders, hemophilia and other chronic conditions – had a 42% five-year average ratio of capital expenditures to EBITDA (earnings before interest, taxes, depreciation and amortization), according to S&P.

The accelerated depreciation could also provide an incentive for healthcare providers to boost capital spending, which could provide a sales boost to healthcare equipment providers including Baxter, BD (NYSE: BD), Hill-Rom (NYSE: HRC), Dentsply Sirona (Nasdaq: XRAY), and Hologic (Nasdaq: HOLX).

3. Elimination of U.S. taxes on foreign earnings: It actually has a downside

The tax reform did away with U.S. taxes on corporations’ future foreign earnings – including repatriation of cash. The provision, according to S&P, represents a “permanent reduction in a company’s tax obligation and gives companies greater access to cash from profits generated overseas.”

However, medical device company investors could pressure leadership to use the money not only for debt reduction but also for share repurchases and M&A deals that could further weaken the companies’ creditworthiness, S&P reports.

For example, Abbott (NYSE: ABT) would see its adjusted net debt leverage rise to 5.0 times EBITDA if all the cash went to shareholders, up from an adjusted net debt leverage of 2.0x in 2016, according to S&P. It would rise to 3.0x if shareholders only got half the cash. Medtronic (NYSE: MDT) would see its leverage rise to 3.8x if shareholders received all the cash, up from a previous adjusted net debt leverage of 2.5x.

The tax reform also includes a deemed tax on previously untaxed profits earned overseas – with companies paying the tax over the next eight years. Medical device companies with billions of accumulated foreign earnings in their most recent fiscal year include Johnson & Johnson (NYSE: JNJ) ($66.2 billion), Medtronic ($31.8 billion), Abbott ($24 billion) and Danaher (NYSE: DHR) ($23 billion), S&P reports.

4. There’s a lot of uncertainty, too

The new tax reform law left some major unanswered questions when it comes to the future of the U.S. healthcare system and the medical device business:

  • The tax cuts will increase the U.S. budget deficit by $1.5 trillion over a 10-year period, according to the Congressional Budget Office. S&P predicts that Congress will seek to reduce Medicare and Medicaid expenditures to reduce the debt. Less healthcare spending could equal less medical device sales.
  • The tax reform also economically undermined Obamacare by doing away with the mandate that individuals have health insurance or pay a fine through their taxes. The situation could also potentially reduce healthcare spending.
  • The 2.3% excise tax on U.S. medical device revenues is also back in effect now that a two-year moratorium expired. Medical device industry leaders had hoped the tax reform would kill the excise tax for good or at least extend the moratorium. It did not, though Congress may address the device tax as it seeks to avert a government shutdown.
From the Hospital Bed to the Finish Line

textadimage Heidi Dohse was diagnosed with a rare arrhythmia in 1982 and has been 100% pacemaker dependent for over 30 years. With the help of wearable devices, she has been able to pursue her dream to become a competitive cyclist.

You can hear her story and more when you register for DeviceTalks Boston, October 8-10.


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