Citigroup is running out of accounting tricks and the stock will continue its slide as investors recognize the company is not as profitable as it leads investors to believe. Our analysis of the financial footnotes of more than 50,000 annual reports means we know more about which companies have the naughtiest and the nicest accounting. And Citigroup is definitely on the naughty list.
As one of May’s most dangerous stocks, Citi is guilty of both misleading earnings and an undeservedly high stock valuation. We think the two are related as Citi’s overstated earnings have helped prop up its stock.
This article aims to help investors avoid the potentially large losses that may be incurred by owning Citi (or any ETFs and mutual funds that hold it) by revealing details behind Citi’s manipulation of its earnings over the past couple of years.
The chart below plots the steady rise in the difference between reported GAAP earnings and the company’s economic earnings from 1998 to 2010 on an aggregate basis as well as a percentage of revenues. In 2010, the level of overstatement reached an all time high of $51.8 billion and 60% of revenues.
(Click chart to expand)
Citi’s Overstatement of True Profit Is Reaching Extreme Levels
Sources: New Constructs, LLC and company filings
The rather large divergence between reported and economic earnings is made possible by accounting rule manipulations, which we explain below. Note that we are not saying that Citi is breaking any formal laws or rules. They are simply playing the same earnings management game that Wall Street has been playing for years. The difference now is that I believe the game is ending for Citi.
Late last August, we wrote about the abnormally high deferred tax asset (over $50 billion) on Citi’s 2009 books that artificially boosted reported earnings and capital. Though Citi tried to sweep the issue under the rug, CLSA analyst Mike Mayo and I pointed out that in order to justify carrying such a high deferred tax asset, Citi would have to generate over $4 billion in taxable income every year for the next twenty years, which seems a little aggressive given the company’s five-year average pre-tax income was a loss of $16 billion per year. Citi would have to achieve a rather epic turnaround to justify carrying such a large deferred tax asset.
Undeterred, Citi upped its deferred tax assets (“DTAs”) in 2010, by another $5.3 billion, or 10%, to over $56.4 billion, more than one-third of the company’s book value. Given the importance of book values to the capital requirements of banks, one can understand how much Citi has to lose if it had to write-down the DTAs.
$5.0 billion of the increase in the deferred tax asset is due to FAS 166/167 requirements to reconsolidate previously-off-balance sheet assets. However, that Citi’s $13.2 billion in pre-tax income in 2010 would not have offset at least part of the increase in DTAs related to FAS 166/167 is suspicious.
Even more suspicious is how Citi’s “tax credit and net operating loss carry-forwards” increased to $23.3 billion from $20.8 billion in 2010, over 2009, despite recording the rather substantial pre-tax profit of $13.2 billion. Typically, a company’s tax credit and net operating loss carry-forwards are reduced when it generates a profit because the cumulative value of its losses is reduced by the most recent year’s profit. If you don’t believe me, you can see for yourself on page 180 of Citi’s 2010 10-K.
We think it is pretty clear that Citi has taken license to do just about whatever it takes to boost capital levels, please regulators and keep the stock price propped up. In this matter, having the US Treasury as one of your major shareholders probably does not hurt.
But wait, there is more that we find buried in the footnotes. This time, we reveal that Citi understates its provision for loan losses and boosts reported earnings by about $5.7 billion, 7% of revenue.
Just looking at the loan loss reserves on the balance sheet, one would assume Citi’s provision for loan losses was greater than the company’s charge-offs because the loss reserves rose from $36.0 billion in 2009, to $40.7 billion in 2010. Digging deeper, we find that Citi’s provision for loan losses actually understates charge-offs by about $5.7 billion because the increase in the overall reserve level comes from reconsolidation of previously off-balance sheet assets, per implementation of FAS 166/167. No wonder Citi was able to record a provision for loan losses of only $26.0 billion in 2010, versus $38.8 billion in 2009, even though gross charge-offs were $34.5 billion in 2010.
This article provides strong evidence that investors should not trust what they see in reported earnings and press releases. Anyone who thinks that the post-subprime financial regulatory reform has reformed Wall Street is sadly mistaken. Instead, companies are just better at hiding their financial faults as evidenced by the increase in the length and complexity of annual reports. Enron, Tyco, WorldCom, Countrywide have taught us, time and again, that reported financial statements in their current form are simply not reliable.
Stocks make our most dangerous list when questionable earnings are combined with an expensive valuation. And here, Citi’s stock fits the bill.
To justify its current stock price of about $41, the company must grow its after-tax profits at over 16% compounded annually for more than 20 years. Or more simply, the current stock price implies a 720% increase in after-tax cash flows. Wow.
With no future profit growth, the value of Citi’s stock is closer to $5.65 per share.
C gets our “very dangerous” rating because we believe the downside risk dwarfs the upside potential of the stock. We recommend selling or shorting Citigroup’s stock as well as the following financial sector ETFs because they allocate a significant portion of their assets to Citigroup:
- iShares Dow Jones US Financial Services (NYSEARCA:IYG) – “dangerous” rating with 8.7% allocated to Citigroup
- KBW Bank ETF (NYSEARCA:KBE) – “very dangerous” rating with 6.9% allocated to Citigroup
- Select Sector SPDR-Financial (NYSEARCA:XLF) – “dangerous” rating with 6.5% allocated to Citigroup
- Vanguard Financials Index Fund (NYSEARCA:VFH) – “dangerous” rating with 5.3% allocated to Citigroup
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.