February 2012


They say there are two certainties in life, death and taxes.  That’s not entirely accurate since death comes at the end of life, but that is probably just quibbling.  Taxes are a certainty however, whether of not you choose to pay them.  If the 2012 presidential campaign has illuminated anything definitive to date, it is that not all income streams are equal from a tax standpoint; those who make the majority of their income through buying and selling investments (the Mitt Romney’s and Warren Buffet’s of the world) have much lower effective tax rates because their income is treated as capital gains instead of ordinary income — 15% versus 35% at the highest level.  Some form of equity is looming on the horizon.

In 1993, the Clinton Administration sought to tackle a $300 billion federal deficit through government spending cuts and increasing personal income taxes on top earners.  This resulted in a budget surplus in 1998, which grew to $230 billion by 2000. The surplus was a central discussion point in the 2000 presidential campaign.  George W. Bush suggested America was “owed a refund” and campaigned under a promise to lower taxes on the wealthy if elected.  The net result was the 2001 Economic Growth and Tax Relief Reconciliation Act and 2003 Growth Tax Relied Reconciliation Act, collectively referred to as the “Bush Tax Cuts”.

The Bush Tax Cuts lowered ordinary income tax rates 3%-5%, phased out the estate tax, reduced the marriage penalty, lowered rates on income from dividends and capital gains, and increased exemptions.   Critics argue over the long term impact of these changes, but two things are hard to dispute: a) the Bush Tax Cuts resulted in U.S. government losing billions of dollars of revenue over a 10 year period and b) keeping the cuts in place have become a central political platform for the Republican party.   While I am no political handicapper, the combination of a swelling U.S. deficit (and therefore the need for more revenue streams), the growing income gap between the wealthy and the middle class (as evidenced by the “Occupy” movement), and the clear improbability of the GOP winning both the White House and the Senate, mean the Bush Tax cuts are all but dead on the stroke of midnight December 31, 2012.

The implications of Cinderella leaving the ball are meaningful, as evidenced by the table below:

Estimated Changes Upon Expiration of Current Tax Program
2012 2013E % Increase
Ordinary Income 35% 43.4% 24%
Long-Term Capital Gains 15% 23.8% 59%
Qualified Dividends 15% 43.4% 189%
Estate and Gift 35% 55% 57%
Source: Moss Adams LLP Year-End Tax Planning Guide, November 2011

The question many are asking is whether these changes may light a fire under M&A for family owned businesses in 2012.   After all, if you own a business worth $100 million and  you sell in 2012 versus 2013 you save yourself at least 8.8%, but possibly much more if the”Buffet Rule” is enacted into law, which would put a minimum tax rate of 30% on all income streams if you make over $1 million annually.

History would tell us that taxes alone are not sufficient enough to push people towards transactions they would otherwise defer.  However, history has not seen this level of increase in the capital gains rate since the 1967 – 1972 period when rates increased 11.5%, but over a period of five years.  Here we are talking about 8.8% over night.  Further, the market has never enjoyed the levels of liquidity currently in the marketplace, from both strategic acquirors and private equity firms.  Excess liquidity tends to correlate with rising purchase prices.  Throw in a pinch of uncertainty regarding Europe over the next 24 months and you might have a convergence of circumstance strong enough to call some to action.

Despite the stars aligning only a subset of the market should be interested in this reality, and that would be companies on the larger end of the spectrum.  Yes, as enterprise value increases the impact of the capital gains rate changes increases, but more importantly so do transaction market multiples.  According to GF Data Resources, the spread between the multiples garnered by businesses worth greater than $50 million is a fully 2.0x in a leveraged buyout versus those with lower enterprise values.  The data shows that the “size premium”, so to speak, increased a full 1.0x in 2011.  Absent attractive purchase prices, people tend to sit on the sideline no matter how their tax bill changes from one year to the next.

Net net, I think 2012 will be a strong year for M&A because of the total market dynamics, but I don’t think taxes alone are going to stimulate a plethora of activity that would not otherwise be there on other merits.

/bryan

In order to experience some modicum of success as a writer, you need to provide compelling content that people want to read.   In our media blitzed society this generally requires one to take a provocative position on some issue.  While I certainly try to challenge my readers to think more broadly on a range of topics related the pet industry, there are only a few storylines where my rabble-rousing has enjoyed a high level of consistency;  the topic of Petco is one of them.

Again, let me state I have nothing against the company per se.  In fact, Petco, and its better looking twin sister Petsmart, provide a necessary and valuable service to both companion animal owners and the industry at large.   That said, they suffer from a fundamental structural challenge, namely their access to cheap high quality labor is limited, which undermines their ability to effectively service customers on a consistent basis.

The other area where I say the “dog has fleas” with respect to Petco is when comparing it to Petsmart.   I wrote about it here.   The basic premise was while the industry had grown nicely since Petco was taken private for a second time, the financial disclosures related to its recent debt refinancing implied that Petsmart had put Petco in its rear view mirror.  I then left it at that.

Unbeknownst to me, San Diego Reader columnist Don Bauder decided to pick up my ball and walk it over to Petco headquarters (also located in San Diego).   He put my musings to Petco Chief Financial Officer Mike Foss here, in an article questioning the benefits of buyouts.

Notably, in Bauder’s article, Foss asserted that “By virtually every single metric — sales, profit, cash — we’re better off than in 2006.”  Given the size of the debt refinancing it is easy to see how profits and cash are up, because interest costs are down and debt is up, albeit not enough to offset the decrease in the effective interest rate as, according to Foss, Petco’s refinancing is saving it $18 million in annual interest expense.   It’s not hard to believe that sales are up either given that the market has grown consistently over the past five years and the pet majors have maintained the lions share of the retail industry’s sales.  What is more notable to me, however, is that Foss said nothing about operating cash flow or same-store-sales, the two most important metrics to measure the health of a retail property.

Net net, while Foss may dispute my assertion, he certainly did little to refute it.   Further, if my analysis was really that wide of the mark, he wouldn’t even have taken the time to put his spin on the situation.

/bryan