Mike Mayo vs. Citigroup on deferred taxes: round III

Mike Mayo’s writing about C’s deferred tax assets again.  They now amount to over $50 billion and Mr. Mayo thinks at least part should be written off and removed from C’s balance sheet.

Mr. Mayo, a respected Wall Street bank analyst now working at CLSA, has always spoken his mind, even when he knows it will arouse the ire of the major commercial banks he covers.  Banks–like any large-cap publicly listed companies–know how to play hardball.  They can, and have, cut off his access to top management, and they can deny his employer their securities underwriting, and other investment banking, business.  But that has never stopped Mr. Mayo–who (perhaps out of necessity) has worked for a variety of Wall Street firms over his career.

Last year, Mr. Mayo predicted that C would write off $10 billion in deferred tax assets from its balance sheet at yearend.  The company didn’t, explaining in its 10-K that if all else failed it would repatriate massive foreign accumulated profits to enable it to use the tax losses has accumulated on its balance sheet.

So, Mr. Mayo’s writing again.  Why?  –because C’s deferred tax account has continued to grow, reaching $50 billion at the end of the June quarter–or a third of the bank’s tangible equity.  The number is also very big relative to C’s market capitalization of $110 billion.  If they could all be used today, they would probably represent C’s single most important asset.

That’s the question, though.  They can’t all be used today.  In fact, C is generating more of them.  But can they all ever be used before they expire?  Mr. Mayo thinks not.  C says they will be.

My guess is that Mr. Mayo is technically correct, but that we won’t see a writedown for several years, if we ever do.  Two reasons:

–I don’t think the authorities see any percentage in portraying a major commercial bank as being in worse financial shape than its audited financials show it to be now.  At least a portion of the deferred tax assets are counted in the regulatory capital supporting C’s loan portfolio.  No one wants to mess with that at the moment.

Furthermore, C is not alone in having substantial deferred tax assets.  A C writedown might snowball into an investor demand for similar writedowns by other European and US banks.  That would be playing with fire, also.

–There’s a technical reason, as well.  It’s important to distinguish between a company’s financial reporting books, which it presents to investors, and its tax books, which it shows to the IRS.  A company may take a writedown of, say, $10 billion in US assets on its financial reporting books.

Let’s assume, to keep matters simple, that it has no other taxable US income.  If so, on its income statement, the company will show a pretax loss of $10 billion, a deferred tax benefit of $3.5 billion and an after-tax loss of $6.5 billion.  In the footnotes to its financials, it will show a tax carryforward of $3.5 billion.

What’s crucial is that it uses this accounting treatment whether it actually disposes of the assets or retains them at a nominal value on the balance sheet.  And it may not want to sell the assets right away.

Why not?  –because disposal of the assets is what starts the clock ticking on the limited time a company has to make use of the tax losses.  If you’re not making money now, it’s often better to hold off on disposal.  Doing so can extend the time you have to use the lax losses indefinitely.

In C’s case, we don’t know the details of what it has done.  Only C and its auditors know for sure.

Again, why am I writing about this? I think the C tax controversy is interesting, although I don’t own C and have no intention of buying any soon.  I also am intrigued by the idea that yesterday’s loss can be tomorrow’s asset value.  That can be a key issue in evaluating fallen angel bonds or turnaround stocks.  It also has important implications for mutual funds and ETFs, especially in times like these when the securities have big realized losses and are experiencing redemptions.  More on this last topic in a later post.

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