Investors Beware: These Profits Are Fake

Marie is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The S&P 500 rose a whopping 14% this year, outperforming the most optimistic forecasts. Unfortunately, the market may not be as robust as this figure may make it appear. According to The Wall Street Journal, S&P 500 bottom line profits have risen 7% year-over-year, but pre-tax profits have grown less than 1%. Have companies been cooking the books to show inflated profits, or is there another explanation for this significant difference? 

Since the 1980s, the government has issued a tax credit for research and development. The credit is not permanent and expires from time to time. 2011 marked its most recent expiration. Instead of being renewed immediately, it was incorporated into the fiscal cliff deal, which didn’t pass until early 2013. As a result, 2012 was a year devoid of research and development tax credits for corporations. 

Taking credit

When the deal passed, companies were permitted to deduct credits unused from 2012, along with their credits for the first quarter of 2013. Large tax breaks lead to shockingly low tax bills for many closely-followed companies, bolstering their bottom-line profits. Investors who didn't know this could easily lose sight of the actual profitability of the following companies.

Google

Tech companies invest heavily in research and development in order to stay competitive. Google (NASDAQ: GOOG) is no exception. In the first quarter of 2013, Google reported net income of $3.35 billion, up from $2.89 billion year over year. 2012’s research and development credit allowed Google to receive a $380 million tax break. The credit represented the bulk of its earnings increase, and reduced Google’s company-wide effective tax rate to just 8% for the quarter.

A company as large as Google doesn't receive such a low tax rate through one tax credit alone, however. Google’s complicated yet effective scheme sends revenue to Ireland, the Netherlands, and eventually to Bermuda, where the corporate tax rate is 0%. Nevertheless, $380 million is sizable savings to any company. Unless Google can raise its bottom line the old-fashioned way, its tax credit will be noticeably missing from next quarter's profits.

Yahoo! 

Not far behind Google is Yahoo! (NASDAQ: YHOO). The off-brand search engine doesn't have pockets as deep as Google's, yet it still managed to spend $886 million on research and development in 2012.

But after spending $1 billion to acquire the blogging service Tumblr, Yahoo! might not have the budget to devote as much on R&D in 2013. This would spell higher tax rates, since its research and development credit would be smaller, ultimately reducing Yahoo!’s bottom line.

Year-over-year revenue fell 6% in the first quarter, yet the company still reported a 36% earnings increase. With a first quarter tax rate of only 7.1%, it’s easy to see why profits rose.

Intel

The world’s largest producer of semiconductors, Intel (NASDAQ: INTC) is no stranger to research and development. At $10.1 billion, no company spent more on research and development in 2012. Yet despite a $290 million savings on last quarter’s tax bill, the company’s profit fell 25% from last year.

A sagging bottom line isn’t shareholders only concern. Intel plans on launching its own television service by the end of year. With no experience in the industry, and an already crowded marketplace, critics doubt the viability of this service. Unless Intel can find new business in its core chip market, its future looks lackluster.

Boeing

Airplane manufacturer Boeing (NYSE: BA), spent $3.3 billion on research and development in 2012. Its large investment is the result of pressure from politicians, customers, and competitors to make its planes more efficient and environmentally friendly.

Last quarter the company reported a 20% year-over-year increase in net income, yet revenue fell about 5%. Its $145 million tax credit provided the company with an effective first quarter tax rate of just 23%. A significant decrease from its 2012 tax rate of 36%.

Falling revenues typically don’t lead to higher valuations. With Boeing stock up 30% this year, next quarter's earnings may leave investors dissatisfied.

Caterpillar

It’s been a disappointing first quarter for Caterpillar (NYSE: CAT). In a year marred with layoffs, union negotiations, and slumping sales, Caterpillar reported net income of $880 million, down 44% from $1.5 billion a year ago. Taking into account its 2012 research and development of $2.4 billion, the company saved $87 million from Uncle Sam’s coffers.

Additionally, Caterpillar lowered its gloomy full-year earnings outlook to $7 a share, down from its previous estimated range of $7 to $9 per share. The company expects sales to remain stagnant in-between $57 and $61 billion. As global economies struggle to recover, Caterpillar remains stuck in the mud.



Accrual reality

The outlook for these companies is admittedly mixed. Only one thing is for certain: Next quarter, tax rates will rise when companies receive a tax credit for just one quarter of research and development, instead of five quarters of R&D. I expect profits to fall accordingly, sending unaware investors an unpleasant surprise when they notice a drop in profit margin (and probably share price).

Proponents of the efficient market theory would argue that the tax credit is already baked into the stock’s price. I disagree. Long-term investors who read and study company financials likely have noticed the tax provision, but unfortunately, the studious investor is a dying breed. Be diligent in your research, and find the source of company profits. Your portfolio will see a "real" difference.


This article was written by Joshua Sauer and edited by Chris Marasco. Chris Marasco is Head Editor of ADifferentAngle. Neither has a position in any stocks mentioned. The Motley Fool recommends Google and Intel. The Motley Fool owns shares of Google and Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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