The Wall Street Journal reported on Friday that long-time Wall Street bank analyst Mike Mayo told clients in a conference call he expects Citigroup will write off $10 billion in deferred tax assets in December.
Who is Mike Mayo?
He’s an experienced, well-respected sell-side bank analyst. I don’t think I’ve ever met Mr. Mayo, who now works for French broker Calyon, but I’ve known and used his research for years. We may even have worked for the same firm for a brief period.
Mr. Mayo periodically draws the ire of bank managements–with not always positive career consequences for himself–for his research findings. His conclusions, which I think have generally proven to be correct, at times call attention to previously unnoticed company missteps. Or they may just not be sufficiently bullish to suit company managements that regard analysts as extensions of their public relations efforts, rather than independent researchers.
To understand what he’s saying about Citigroup now, you have to know some thing about what deferred taxes are.
Deferred taxes
Publicly listed companies keep several sets of books. Among them are the tax books they use in reporting to the Internal Revenue Service and financial reporting books they use in reporting to shareholders. Taxable income is typically lower in the reports to the IRS than in those to shareholders. Deferred taxes are a way of reconciling the two sets of books.
An example:
Let’s say a company has a pre-tax loss of $1 million, and has used up its ability to receive a refund from the government for taxes paid in prior years. For the IRS, this result is reported as an after-tax loss of $1 million. The company is able to carry forward this loss, however, and use it to offset future years’ taxable income. Rules vary from country to country.
In its financial reporting, the company will record a pre-tax loss of $1 million, just like it will for the IRS. But, in contrast to the IRS filings, it will also record–as a reduction of the current loss–the value of future tax benefits that this loss potentially gives the company. In this case, let’s say that’s $350,000. Under financial accounting rules, then, the company will report a net loss of $650,000 to shareholders and record the $350,000 on the balance sheet.
If the company makes $1 million pre-tax next year,
1. it will record the $1 million in taxable income in its IRS filing, but subtract the $1 million tax loss carryforward and pay $0.
2. To shareholders, it will report $1 million in pretax income, subtract $350,000 in deferred taxes from that (and remove the balance sheet entry) and report $650,000 in aftertax profit.
Notice that the overall result in both cases is zero. The effect of deferred tax accounting is to make a loss-making company’s results look better in the loss-making years, at the expense of making future profits look worse.
One exception
In order to use deferred tax accounting, a company–and its accountants–have to be convinced that the firm will be able to make enough future profit to actually use the tax loss carryforwards it is taking credit for on the financial reporting books.
In particular, if a company’s fortunes deteriorate after having used deferred taxes to minimize current losses, and it finds it won’t be able to earn enough to actually employ them, it has to write them off.
Finally, to Citigroup
Citigroup had a little over $44 billion in deferred tax liabilities on its books at the end of last year. According to Mr. Mayo, the company will write off $10 billion of them at yearend.
Typically, a firm’s auditors compel the company to make a writedown like this. And, unlike Mr. Mayo, accountants are, in my experience, concerned enough about the egos of a client’s top management that they will not do so unless there is overwhelming evidence supporting their conclusion.
So what Mr. Mayo’s statement, if correct, implies to me is that:
1. the auditors now realize that Citigroup will be significantly less profitable in the future than they had thought less than a year ago,
2. past earnings have been inadvertently overstated by $10 billion, and
3. the burden of proof has shifted, away from thinking that the other $34 billion is a conservative number, to worrying about that, too.
Normally, writedown of deferred taxes is an ominous sign for a stock. And $10 billion is about a tenth of Citigroup’s market cap. It’s unclear to me in this case, however, whether the writedown Mr. Mayo talked about is an industry phenomenon or something specific to Citigroup.
It also isn’t clear to me even how one could figure out the possibility of such a writedown for a complex multinational business like Citigroup. My best guess is that this relates to some (unknown to me) legal or regulatory change in the UK, where US firms domiciled much of their activity in toxic assets.
Stay tuned.