Call it the lottery winner's dilemma: When you have money, everyone else has an opinion about how you should spend it.
This should be especially familiar to investors in Citigroup (NYSE:C) stock. For months, investors have been debating the large, and growing, $55 billion pile of "deferred tax assets" that sits like a lodestone upon Citigroup's balance sheet. Hardly a day -- or at least a quarterly earnings call -- goes by without some analyst or other voicing some bright idea about what Citi should do with its "DTAs."
Amidst all this navel-gazing, I have to admit -- I got curious, too. So I began digging into the issue, and just in case you'd like to know what's up with all this "DTA" talk, I'm here to lay it out for you.
Begin at the beginning
So first step: What is a deferred tax asset, anyway, and where did it come from?
Basically, Citi's DTAs arose from the company's incurring losses and taking deductions during the bad old days of the Financial Crisis. As a general rule, losing money is not a good thing, but it did have one benefit for Citigroup stock -- it allowed the bank to pile up tax credits that it can use to offset any profits it might earn going forward. These tax credits are what we're talking about when we say "DTA."
Now for the problem
Problem is, Citigroup needs to earn a lot of profits if it's to offset $55 billion in historical "losses." The pile of DTAs weighing on Citigroup stock has grown from $38 billion in 2009 to $50 billion in 2010 to $55 billion currently. But now that Citi has them, it has to figure out how to use them. Else, CFO John Gerspach notes, the bank's ability to make loans, buy back stock, and pay dividends under strictures set up by Basel III rules could be restricted.
Gerspach isn't too worried about this, however. He's on record saying that Citi will "more likely than not" be able to use the entire DTA pile eventually, "based upon expectations of future taxable income in the jurisdictions in which the DTAs arise."
But how? I see three options.
Sell profitable stuff ...
One option: In 2009, The Wall Street Journal cited anonymous sources suggesting Citi was shopping around its Banamex Mexican subsidiary. Assuming Banamex has appreciated in value over time, Citi could book profits on such a sale and set off part of its DTAs against those profits, canceling them out and avoiding paying tax.
The downside for Citigroup stock: Latin America is currently Citi's second most profitable division. Sell Banamex, and yes, Citi may book a big one-time profit. But it will also lose all the profits that Banamex would otherwise have been able to generate for it in years to come.
Then again, if Citi can sell a subsidiary, work a little accounting magic, and pass to its buyer part of its DTAs, along with Banamex itself, this could help it negotiate a bigger purchase price -- potentially killing two birds with one stone. On one hand, the DTAs would shrink. On the other hand, a bigger purchase price for the sold subsidiary would give Citi a bigger profit to set off against the DTAs it has left.
... buy other profitable stuff ...
Another way to earn profits, against which to set off DTAs originating from historical losses, might be to buy a company that's better at earning profits than Citi is. So acquiring a smaller, more profitable company and using its profits to sop up some of Citigroup stock's DTAs is a second alternative.
In fact, Citi has already made moves in this direction, picking up Best Buy's (NYSE:BBY) branded credit card business from Capital One (NYSE:COF) earlier this year. Granted, this move seems to contradict Citi's old strategy of lightening up on credit cards, as demonstrated when it unloaded a $1.6 billion credit card portfolio on General Electric (NYSE:GE) back in 2010. But that was then, this is now, and today, DTAs are the issue that needs fixing.
... or do nothing
Of course, buying new subsidiaries may not be necessary, either. Analysts who follow Citigroup stock project that over the next five years, Citi will earn some $29.28 per share. With 3.04 billion shares currently outstanding, that should work out to $89 billion in profits -- easily enough to absorb the $55 billion in DTAs.
The main problem here is that Citi earns the majority of its profits (61%) outside U.S. borders. Since most of its losses (which created the DTAs) were incurred within the U.S., though, offsetting foreign profits with domestic losses could be easier said than done. The numbers may not line up right. Still, assuming Citi continues earning Stateside profits at its current pace, 39% of total profits of $89 billion could absorb a goodly chunk of its DTAs -- $35 billion worth, or thereabouts.
Search deeper in the tool chest
Other options for Citigroup stock might include surprising analysts and earning more profits than are currently expected from its credit card division. Or Citi could "create" U.S.-based profits out of thin air by drawing down its reserves against mortgages going bad. When money is diverted into a loan-loss reserve, it decreases profits. Reversing such shifts, accordingly, helps to increase a bank's reported profit.
The upshot, though, is that CFO Gerspach is right. Citigroup stock has lots of tools in its tool chest. One way or another, it'll find a way to chip away at its DTAs.
Fool contributor Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Citigroup and General Electric. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.