My last article prompted a curious one to be written by Seeking Alpha contributor Josh Arnold. I say curious, however, because it on one hand gives credit to my view but then takes issue with my conclusion with a very faulty argument.
I have absolutely zero emotionally invested in both articles and am only writing this response to clear up some incorrect statements that, to be fair, appear not only in his article but many other earnings-related comments. I'm invested in Bank of America (NYSE:BAC) and in no way trying to burn the bank but I am constantly looking for holes in every one of my investments. Why? Because I don't want my money to fall through them. I'm already in and I am not looking for someone to cheer me on. What I am looking for is protection and when I hand over my money, the only way I know how to get that is by keeping an eye on the business and adjusting my expectations accordingly. I may drive with only one foot but I do have two pedals and I think it would be wise for everyone to use both and mind the road signs.
With that said, the author indicates that the deferred tax asset is valuable because it can lower the bank's tax rate. This is untrue. The DTA is more of a prepay that will be used, when it can, to lower the cash payment of the bank's tax bill. Because of this, it is balance sheet related and has nothing to do with earnings. Once on the balance sheet, it does not lower any expenses. If the bank showed a lower expense, it's because they had less accounting income (different from taxable income) in the current period. I repeat, it does not affect this expense. It only affects the payment of the expense. This absolutely makes it far from what the author called a "real money-maker for shareholders."
The author also said, "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, again, absolutely incorrect. The DTA already flowed through to capital and retained earnings when it was created. It is an asset and already makes up a part of retained earnings (and a very large part at that).
The "earnings advantage" that Bank of America investors got, that's past tense by the way, was in the form of reporting smaller losses in the PAST. There are no future earnings advantages and the only "real money" that can flow back to shareholders when the DTA is drawn upon is only the money that was not used when this ALREADY reported asset is spent. Spent, meaning subtracted from, to balance out the current income tax expense with the actual amount of cash used for payment.
I would trade this asset for cash any day and that's the task that Bank of America tax professionals are working on. But again, this is not an addition to assets, it only represents a potentially lower cash payment for taxes but it requires the removal of the DTA to realize it (over what will be a very long time). The net change to assets is the same as it would be after any tax expense except that you use the DTA instead of the cash that you would have used without it. On the other side of this, equity is written down by the full tax expense that came with earnings but you now have more "real money" assets representing equity then you did before when you where holding on to the DTA (that is a positive by the way so don't think I'm just trying to be negative). I'd like to point out that this more positive equity mix is based on a lower amount of assets and equity being made up of the DTA (one of my original main points and the reason why I think Bank of America is already being valued more highly than a price to book value comparison would indicate).
There is no outflow or inflow of cash because of the use of the DTA. There are only cash savings but the possibility of not using the full DTA over the next 20 years, though unlikely, makes it more like a liability to me than an asset. And, any argument that indicates the bank is a lot better off because of the use of the DTA, instead of cash, is a little suspect because this bank appears to be very liquid and the annual amount of DTA used is small in proportion to all assets, including even the undiscounted DTA balance that it's coming from. Also, arguing from this angle is kind of a wash when you consider that the proponents originally started off by saying that the asset was earning money. If that was the case, then what is there to be happy about when the DTA is used instead of any other asset? Based on the original stance taken, weren't they close to the same?
In conclusion, my original article may have seemed "backwards" to some and "sideways" to others but, at its heart, it was my attempt to shine a light on a very large asset that has the ability to completely alter the view of the equity returns that the bank is reporting. Something that I think investors may be interested in and something that I plan on tackling in the near future.
As an aside, the first summary point on the other article says, "Bank of America's deferred tax asset is its single largest asset on its balance sheet." This is wrong and I think we can agree an honest mistake because the bank has over $2 trillion in assets and several lines are larger than the deferred tax asset. Compared to total assets you may consider the DTA to be a drop in the bucket but keep in mind, it now represents ~20% of tangible shareholders equity. This is very important going forward because tangible shareholder equity is the basis for returns that management has been guiding investors on (more on this later).
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.
Additional disclosure: I am long BAC through warrants.