How Tax Reform Will Affect These 2 Stocks

Given the implications of Chile's tax reform, what's the outlook for Sociedad Quimica y Minera de Chile and Banco De Chile?

Apr 15, 2014 at 6:34PM

At a time when the Chilean economy is cooling and investment is already falling, the local government presented a package to reform the nation's tax system.

The new measure proposes a reduction in the top personal tax rate from 40% to 35% while increasing the corporate income-tax rate. It also includes a measure to make corporate income tax calculated on accrual, rather than the current cash basis. This accounting change will make companies pay taxes for operations that took place during the current income statement, even though that income may not be received until the next fiscal period. The effect of this modification is neutral in the long run, but it can generate higher tax payments in the first fiscal period.

The reform is extensive, as the new tax regime would increase the Chilean government's haul by about $8.2 billion annually -- that's 3% of GDP.

Chilean President Michelle Bachelet, a Socialist, made tax reform a key part of her election platform -- and she won, taking office a month ago. Bachelet was also head of state between 2006 and 2010.

The tax reform is meant to be progressive, aiming to improve tax equality within Chilean society. In addition, it is meant to finance a reform in the education system (which was spurred by several violent social conflicts lately) and other social programs.

Impact on companies
Digging deeper, the reform calls for an increase in the corporate tax rate from 20% to 25% by 2017. The measure would also end a corporate tax break known as the FUT, which allows companies to defer tax payments on profit retained for future investment. The bill will also end a statute that gives foreign investors certain tax guarantees.

These two measures will definitely impact mining companies operating in the country, such as Sociedad Quimica y Minera de Chile (NYSE:SQM). Why? These companies hire a great number of contractors for exploration, studies, extraction, logistics, and other research. Many are foreign and capital-intensive. The elimination of the FUT will remove an incentive for companies to allocate money to investments, and these companies will also be paying more in taxes -- not the best of scenarios.

However, right now, Sociedad Quimica has other issues in mind, as five locations where the company operates are within 300 miles of the epicenter of the recent earthquake that took place in the north of Chile. Fortunately, the preliminary studies show no structural damage, and no employee casualties were detected at its production facilities. Normally, earthquakes are not single isolated incidents; there could be new quakes coming in the area, and the formations where the company operates could suffer alterations and environmental damage.

The company's 2013 performance was not the best, showing a 28% year-over-year decrease in net income. Gross margin shrank from 42.3% to 32.7%. The results are explained by a substantial drop in potassium chloride and potash prices.

Despite the poor results, the fundamentals remain good for the company, which is a low-cost producer with top market-share positions in specialty fertilizers, lithium, and iodine. It also has an industry-leading position in potassium nitrate. In fact, Sociedad Quimica holds 25% of global market share in iodine and 30% in lithium production. The prospects are amazing for these two products. Iodine has applications in liquid crystal display screens and X-ray machines, which should increase as the population ages and emerging markets develop. For lithium, the outlook is even better, as it is a key component in batteries.

Will the new policy benefit banks?
The tax reform eliminates taxes on long-term deposits up to $91,575, encouraging more people to make deposits, benefiting banks like Banco De Chile (NYSE:BCH).

With the new measure, the bank should be able to capture more deposits and lend more. Banco de Chile has the strongest market recognition among Chilean banks. Plus, the company ended 2013 with the highest return on average equity in the local industry, reaching 21.3%. Net income grew 10% year over year to $940 million. The bank is the largest in terms of current accounts and the second-largest in terms of total loans. So, if there is a bank that can capture the growth in deposits, it's this one.

In addition, Moody's assigned an "Aa3" debt rating to the bank's latest issuance of fixed-rate senior notes, which took place in Switzerland. According to the agency, the principal risk to Banco de Chile's profit performance is the potential for asset-quality deterioration as the economy decelerates, particularly in the higher-risk consumer and small and midsized business segments.

Nonetheless, Banco de Chile's exposure to these segments remains relatively low thanks to the bank's substantial loan-loss reserves and cash capital.

Bottom line
This new tax package comes when Chile's economy is showing signs of a slowdown. True, the government got the votes it needed, giving it the right to raise taxes for good causes like education. The problem is what the cost will be in terms of growth; hopefully, it's not too high.

The bill is expected to pass through Congress with ease, given that the government only needs (and indeed has) a simple majority for its approval. The opposition cannot really push for modifications. The effects of the law will not be immediate, though. In its best-case scenario, the bill will become a law by August, and most elements will be phased in over four years.

Regarding Banco de Chile, the bank is in a great market position to capture the growth in deposits and increase its lending. Its credit ratings and controlled credit risk support it. However, the question remains whether the modification in the corporate tax would offset the benefits of the growth in activity. The answer is directly linked to the overall growth in the country. If the economy deteriorates substantially, the impact will be negative. With a better outlook, though, more money will be captured and lended -- and more profit secured.

Chile's economy grew 4.1% last year, while the previous three-year period saw an average expansion of 5.8%. The growth forecast for this year is currently in the range of 3.75% to 4.75%.

The outlook for Sociedad Quimica is more long-term. The reform will certainly not make things easier, but this year still sounds a lot more promising than 2013. The reason? Fertilizer prices are improving.

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