How the Inflation Reduction Act could impact our auto and drug stocks

We’re taking a closer look at the potential investing implications of the Inflation Reduction Act, which the House of Representatives will soon take up after Senate Democrats passed the sweeping legislation Sunday on a party-line vote . While Wall Street works to get its collective arms around the potential effects of the bill, some research with initial reactions and assumptions is out. That’s what we’ll review here, starting with the tax implications then moving to the auto and pharmaceutical industries. Taxes on companies and stock buybacks As far as investors are concerned, the 15% corporate minimum tax and a 1% tax on stock buybacks are among the legislation’s most in-focus provisions. Some analysts told clients that, based on their initial analysis, the overall impact on earnings appears to be minimal in the near term. In the case of the 15% minimum book tax, part of the reason for that view is it applies to companies that have more than $1 billion in pretax profit (based on a three-year average). Citigroup’s chief U.S. equity strategist Scott Chronert wrote Monday that even though the firm generally views higher taxes as an “economic activity dampener,” other factors such as inflation and Federal Reserve policy have a bigger impact on the earnings of S & P 500 companies right now. “The majority of companies (358 per our math) exceed the $1B average pretax profit hurdle. Of those, only 50 are modeled with a [less than] 15% tax rate on 2023 estimates. Further, those companies account for 15% of index earnings. All else equal, a 15% tax floor would reduce currently expected earnings by -0.42% per 2023 bottom-up consensus estimates,” Chronert wrote to clients. Goldman Sachs estimated the minimum tax impact to be slightly higher, reducing 2023 S & P 500 earnings by approximately 1%. In a note to clients Monday, chief U.S. stock strategist David Kostin wrote that the impact may be more pronounced in sectors such as health care and information technology, which tend to have lower effective tax rates. Wells Fargo’s Chris Harvey found that about 25% of the companies in the Russell 1000 would be subject to the 15% minimum tax based on 2019 earnings. “These firms generated [$1.275 trillion of income] and paid $270B (21%) in total (not just federal) income taxes. While each company’s specific impact should be reviewed, at the macro level we just do not see this as a major headwind for equities,” Harvey wrote. The Citi, Goldman and Wells Fargo strategists also expect the buyback tax to have a muted impact in the near term on S & P 500 earnings, based on their initial analyses. “The proposed 1% excise tax on buybacks would reduce EPS by about 0.5%, assuming no change in repurchase activity,” Kostin wrote. If anything, according to Wells’ Harvey, the potential for a 1% buyback going into effect starting in 2023 could cause some companies to speed up their share repurchase plans in the final months of this year. “At the margin,” the strategist also wrote, a buyback tax could “tilt future capital deployment towards dividends.” To be sure, it is still an evolving situation, Citi’s Chronert cautioned. However, he wrote to clients, based on the current information available the firm’s “takeaway is that the minimum tax and repurchase tax legislation should not be a material negative to aggregate S & P 500 earnings. Stock specific implications should be the more important focus from here.” Incentives for automakers Democrats are heralding the legislation as a landmark victory in the fight against climate change, and they point to a number of incentives related to electric vehicles when making their claim. The exact benefits to a company like Club holding Ford Motor (F) are, for right now at least, slightly murky. The reason for that is electric vehicles must meet strict requirements to be tax-credit eligible. It is believed no automakers, including Ford, currently make EVs that meet all of the Inflation Reduction Act’s eligibility requirements, which cover both battery material sourcing and manufacturing, and vehicle assembly. This means if the bill’s provisions were in effect today, American consumers who want to buy a new EV likely could not redeem the full tax credit up to $7,500. Some EVs on the market may qualify for partial credits. The Alliance for Automotive Innovation, a lobbying group that counts Ford as a member, has criticized the eligibility requirements, which proponents say are meant to bolster the EV supply chains in North America and limit the reliance on China. “[We] share the goal of increased domestic capacity and supply, but the requirements ought to be an inducement to industrial base change — not unattainable and punitive to consumers,” the head of the group, John Bozzella, wrote in a blog post last week. He noted that companies, including Ford, had started to invest in domestic EV manufacturing even before the bill was being debated. “A more gradual phase in of the battery component, critical mineral and final assembly requirements – that better reflect current geopolitical, sourcing and mineral extraction realities – will preserve the credit for millions of Americans and keep the country focused on building domestic supply chains able to support our electrified transportation future.” Under the Senate-approved bill, for a vehicle to qualify for a tax credit at purchase before Jan. 1, 2024, 40% of the critical minerals in its battery need to be “extracted or processed” in the U.S. or a country with which the U.S. has a free trade agreement. That percentage increases by 10 percentage points every year, reaching an 80% threshold for vehicles sold after 2026. Similarly, the bill stipulates that 50% of the components in an electric vehicle’s battery must be manufactured or assembled in North America to be tax-credit eligible before Jan. 1, 2024. The percentage rises from there, reaching 80% in calendar year 2027. Against this backdrop, it’s understandable why analysts at Wolfe Research wrote Tuesday that the Inflation Reduction Act, in its current form, has a “mixed” impact for automakers. “At a high level, there’s no question that this Act will spur an even steeper trajectory of EV adoption,” Wolfe’s Rod Lache wrote. The negatives, for now, are linked to the sourcing and production qualification requirements. However, Lache raises an interesting point in his note — one that also has been discussed in the political press —around the potential for the Treasury Department to waive the eligibility metrics initially, giving automakers time to make good on their already announced North American factory plans. Ford, for example, has already announced billions of dollars worth of investments around batteries and vehicle production, including large-scale projects in Kentucky and Tennessee . While Politico reported there’s precedent for similar kinds of waivers regarding infrastructure projects using American-made steel, it’s hard to know just how likely it is that there would be some for EVs (if the bill becomes law). That said, it’s worth pointing out the existing EV tax credit on the books does not have eligibility requirements tied to where the vehicle’s battery and overall assembly occurs. In the proposed legislation, there also are production tax credits and investment tax credits that cover manufacturing for batteries and also electric vehicles themselves. This is good news for Ford, as well as crosstown rival General Motors (GM). One more EV-related positive in the bill is the elimination of vehicle caps. The existing EV tax credit begins to phase out once an automaker sells 200,000 EVs (and/or plug-in hybrids), a milestone Tesla (TSLA) and GM both have hit already. Ford has 159,588 cumulative sales through 2021, according to the IRS , so the removal of the 200,000-vehicle cap would be helpful for the Blue Oval especially as it expects annual EV sales to accelerate in the near term as new models hit the road. If passed, the legislation would extend the tax credits through 2032. By 2030, Ford expects for more than 50% of its global production to be EVs. It is unclear how the legislation’s eligibility exclusions on EVs that contain critical minerals and battery components tied to foreign entities of concern, such as China, will impact Ford’s relationship with Chinese battery giant CATL . That said, in general we’ve been fans of Ford’s EV strategy and believe the company is a formidable competitor to Tesla, which has long been the dominant player in the industry. With a dividend yield around 3.9%, firmly above that of the 10-year Treasury note, we’re happy to continue being a shareholder while the EV transition plays out. Impact of new rules on drug companies The Inflation Reduction Act (IRA)’s focus on the healthcare front is lowering the cost of prescription drugs, particularly making them cheaper for seniors. The IRA caps out-of-pocket spending for seniors at $2,000 per year, which means, regardless of what their drug balance would be, they would not pay more than that. The bill will require Medicare to negotiate prices for specific drugs each year. It will also cap drug price growth at the inflation rate, requiring drug companies to pay a rebate to Medicare in the event certain drug prices rise faster than the rate of inflation. For Club holdings like Eli Lilly (LLY), Johnson & Johnson (JNJ) and Abbvie (ABBV), we are interested in understanding how the Inflation Reduction Act could impact innovation in the biopharmaceutical field over time, and whether it could impact the companies’ growth. The legislation’s provisions will take three years to go into effect, so as of now it is still uncertain how our pharma holdings could be impacted. But we’ve gathered information that could help us understand how drugmakers feel about the bill, which is set to be passed by Congress. Implications on biopharma product pipeline During Eli Lilly’s latest earnings call, CEO Dave Ricks offered his thoughts on potential implications the bill could have on the drugmaker. First off, Ricks noted that the CPI adjustment is “not really an issue.” “There’s already lots of CPI capping that goes on in the commercial marketplace and with CPI being where it is now, the prices in the drug business are not nearly as fast as the rest of the economy,” he said. While we can’t currently gauge the scope of the impact this bill will have for the drugmaker, it potentially could pose some sort of challenge to its innovative product pipeline that drives the company’s growth. The passage of the bill may have less near-term implications but over time, prescription drug pricing reform could result in biopharma companies like Eli Lilly stepping away from oral oncology research which could influence their revenue opportunities. The biopharma chief alluded to how the bill could impact Eli Lilly’s efforts in oral therapies. “I think you will see 10 years down the line fewer small molecule oral products being developed in the industry if this bill passes,” Ricks said, with each project at the company being evaluated on a case-by-case basis. As investors in the company, we would be concerned as to whether this could yield fewer treatments for cancer, Alzheimer’s and other diseases the drugmaker focuses on. But what the Lilly CEO described as the “most damaging” about the IRA act is “it sends a signal to investors that small molecules in diseases that require step wise development, like cancer, really aren’t wanted and are worth a lot less,” he said. Overall Ricks described the bill as a miss for patients who want better oral cancer treatments and in response to the Act, Eli Lilly and the rest of the sector would have to focus on other areas of innovation. Medicare negotiation provision is a problem Pharma executives largely support Medicare Part D reforms like capping the out-of-pocket costs for patients, which makes medicines more affordable for the elderly population. This provision is expected to have a minimal financial impact to the industry anyway, according to UBS estimates. “We estimate that the impact equates to less than 3% of the global biopharma industry earnings over the Congressional Budget Office’s 10-year budgetary window,” UBS reported. But what healthcare executives find problematic is the requirement for Medicare to negotiate drug prices. Club holdings Eli Lilly, AbbVie and Johnson & Johnson could be susceptible to the IRA’s negotiation bill clause since these drugmakers sell diabetes and oncology treatments to Medicare. In AbbVie’s second-quarter earnings call, the company’s CEO, Rick Gonzalez, said that the bill’s negatives outweigh the positives, specifically when discussing the price negotiation clause for certain types of drugs. “I think the long-term implications of this bill are pretty significant, and they really hinge around this so-called negotiation clause that’s in there and how that’s being implemented, particularly for small molecules,” Gonzalez said. Eli Lilly CEO Ricks echoed Gonzalez’s sentiment saying, “The negation piece is a problem.” Why is it a problem specifically according to the biopharma chiefs? Medicare will initially negotiate prices for 10 drugs that will be covered by Medicare in 2026. That number will increase to 20 drugs whose prices will be negotiated in 2029. The drugs that qualify for negotiation include non-generic drugs from big brands that are 9+ years or 13+ years away from FDA approval. “The key issue is, they (Medicare) have full latitude to basically decide whatever price they want the drug to be,” Gonzalez explained. “We should just call it what it is. It’s price controls is what they’re basically putting in place if the language stays the same,” he said. UBS takes another perspective on drug price negotiation. In its investment research, the analysts suggest the IRA’s provisions are not the worst-case scenario for the sector, and that it could result in a net positive for pharmaceutical companies. “Drugs in scope of the legislation would most likely soon face generic or biosimilar competition which would erode their market share or pricing,” UBS reported. Furthermore, “Expanded health insurance subsidies that this legislation funds would enable more people to afford prescription drugs and potentially increase overall volumes,” the research noted. (Jim Cramer’s Charitable Trust is long F, JNJ, LLY and ABBV. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

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