Yesterday, Profit Fan wrote a very interesting piece on deferred tax assets, or DTA, specifically in reference to Bank of America's (NYSE:BAC) quite sizable deferred tax position. The author makes several salient points regarding what a DTA is and why it distorts traditional valuation techniques such as book value and return on capital. The author then cautions that BAC may not be the screaming value some of us purport it to be. However, I think the argument leaves out important points about DTA and how BAC will use its significant position to create real, honest shareholder value in the future.
To begin, Profit Fan is 100% correct in his assertions about DTA. It's an asset that basically just sits there and does nothing. Following the crisis, these became commonplace on bank balance sheets, from small community banks all the way up to the likes of BAC and Citigroup (NYSE:C) who, to its apparent detriment, owns the largest DTA I've ever personally seen. At any rate, DTA are not desirable outcomes for corporations, as they mean the company has lost large sums of money in the past and, like the author points out, they are assets that earn nothing and just take up space on the balance sheet. As such, no one sets out in business to create DTA on their balance sheet, but if your business is going to lose money anyway, you may as well reap some benefits from those losses down the road.
There is real value in a DTA, and I don't consider BAC to be less valuable due to an "unproductive" asset sitting on its balance sheet. In fact, it's quite to the contrary. To understand my position, we must first understand how a DTA is useful. BAC's DTA will eventually be drawn upon, little by little, as the company continues to earn money. BAC's tax rates have been all over the place of late due to lasting issues from the financial crisis, but as an example, BAC's Q4 2013 tax rate was 10.6%. I bet I'm not the only one that would love to pay that tax rate, but unfortunately, or fortunately I suppose, my family doesn't have any DTA we can drawn upon, so I'm stuck paying my fair share like everyone else.
This is where BAC's DTA's value is shown; this isn't just a pointless asset taking up space, it is a real money-maker for shareholders. If BAC didn't have the DTA, it likely would have paid something like 30% in taxes, but the actual number was a mere fraction of that. Where I believe DTA detractors miss the boat is that the earnings created by drawing upon a DTA is real money that flows through to capital via retained earnings. This is real money that can then be returned to shareholders via buybacks, dividends or simply increased book value over what it would have otherwise been.
BAC's DTA was estimated to be around $30 billion at the end of 2013, but unfortunately, as Profit Fan so adeptly laid out, we have no way of knowing how much of that BAC will actually get to use because of the unholy nature of the rules governing its usage and the mere fact that it expires eventually. However, let's just assume half of that number gets used and BAC can save $15 billion in taxes over the next, say, 10 years. That would mean that, under a pretty conservative scenario, BAC would be able to add $15 billion to retained earnings (capital) that otherwise would have gone to the bottomless pit at First Street SE and Constitution Ave in DC, otherwise known as Congress. This is capital that can be deployed by BAC to buy things, hire people, lend out to customers or return to shareholders in one way or another. The point is that the DTA is not an asset that should make BAC less valuable in the future; on the contrary, I think it gives BAC an earnings advantage over more well-heeled competitors such as Wells (NYSE:WFC) that have no DTA.
I take no issue with Profit Fan's terrific article, as it was a great primer into DTA. I do, however, steadfastly disagree with the author's conclusion regarding BAC's DTA, specifically, as I believe that it is backwards. The author makes terrific points, and if you haven't read that article, please do so, as it is quite well-reasoned. At the end of the day, however, I think BAC's DTA makes it a more valuable company, as its earnings stream in the future is worth more to shareholders than it otherwise would be; I'm simply respectfully taking the other side of the debate.
Disclosure: I am long BAC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.