Bonus Depreciation and a self-imposed Twitter Timeout
How the government is fueling the moats for the Cloud Kings
Charlie Munger is famous for railing against EBIDTA as BS Accounting because it eliminates depreciation as an expense. He’s right, by the way, it is an expense.
Especially in the eyes of the Department of Treasury and the US Government. So much so that the IRS since the Tax Cuts and Jobs Act offers 3 different, stackable tax treatments for Depreciation. Section 179, Bonus Depreciation and MACRS depreciation.
For some of you these may be new terms as investors are more familiar with straight line depreciation which is depreciation for financial accounting purposes. However financial accounting depreciation and tax depreciation are not always the same thing.
Since we are talking about public companies we will exclude Section 179 since it’s irrelevant to businesses that place over 2M in assets into service in a given year.
MACRS Depreciation (Normal Depreciation) is a system of tables and tax treatments which allows you to depreciate an asset much in the same way that a car depreciates. The bulk of it happens in the first few years and slowly tapers down, over the life span of the asset.
Bonus Depreciation has always existed, but in 2018 was changed so that until 2022 100% of an assets depreciation could be taken in its first year. It is limited to non realty assets. So if you have a very profitable, growing, none real estate, cap-ex intense business…in theory you can buy a ton of the assets you need to fuel growth, depreciate them right away, and instead of paying taxes on the profits…re-invest those profits into more assets to grow the business.
I defy someone to find a more perfect business to take advantage of these rules than cloud computing.
Cloud computing is an extremely capital intense business, requiring substantial server and networking assets. All of which are eligible for 100% depreciation instantly.
Don’t believe me…look at the 10K filings for the Cloud Kings
Value of IT Assets on Dec 31
Pre - TCJA (57% increase over 2 years):
2015-13.6B
2016-19.8B
2017-21.4B
Post - TCJA (114% increase over 3 years):
2018 - 30.1B
2019 - 36.8B
2020 - 45.9B
Amazon
AWS Property and Equipment on Dec 31
Pre - TCJA (78% increase over 2 years):
2015 - 8.3B
2016 - 10.3B
2017 - 14.8B
Post - TCJA (116% increase over 3 years):
2018 - 18.9B
2019 - 23.5B
2020 - 32.1B
Microsoft
Computer Equipment and Software on June 30
Pre - TCJA (50% increase over 2 years):
2015 - 10.8B
2016 - 12.4B
2017 - 16.2B
Post - TCJA (216% increase over 4 years):
2018 - 27.6B
2019 - 33.8B
2020 - 41.2B
2021 - 51.2B
When considering these numbers against the law of large numbers…these growth rates should’ve remained constant or decreased. Yet they accelerated. Likely to take advantage of the tax benefits.
As mentioned earlier…these benefits start to sunset in 2022. Meaning capex should likely slow. This should have 2 effects on the businesses.
1.) GAAP profits could likely decrease temporarily. This is due to the need to account for deferred tax liabilities as a result of front running the depreciation. Because the financial depreciation runs at a slower pace than the bonus depreciation…the tax benefits of losses from depreciation will not be realized…as the bonus depreciation means the item would be ineligible for depreciation.
2.) Free cash flows will likely increase. If you assume that they have front loaded their balance sheet with as many assets as possible to take advantage of the favorable tax treatment…then capex will likely slow substantially. Thus freeing cash flows to be applied elsewhere…like to acquisitions, investments or repurchases.
Another name that could be a beneficiary from this tax treatment is Facebook which has also invested heavily in network equipment over the past few years.
Networking Equipment Component of Balance Sheet
2020 — 22B
2019 — 17B
2018 — 13B
2017 — 8B
2016 — 5.2B
2015 — 3.6B
Semiconductor Companies which actually manufacture might be another industry where you could see a substantial stepdown in Capex after the rules start to sunset and fade in 2022.
In Conclusion
Businesses which are asset heavy, input cost light, are being setup to turn into absolute cash flow machines after 2022 given the ability to lower taxes and reinvest into growth. All of these companies are re-investing at unsustainable speeds in an effort to corner their markets and take advantage of the Depreciation Rules from TCJA. In the case of FB and GOOG they are trading at multiples below the broader market, and have higher growth rates. Coupled with the potential deceleration in Capex after 2022, both may begin to return cash back to investors at higher rates.
Personal Note
I’ve taken a break from Twitter. I find it to be too much of a time waster. Constantly seeing the same stocks shilled at me by Twitter’s algorithm, and scrolling mindlessly wastes hours of productive time each week. So for the time being I’ll be away focusing on education and research.