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Cit­i­group (C ) is not as prof­itable as it leads investors to believe.

After ana­lyz­ing the finan­cial foot­notes of 50,000+ annual reports, I know which com­panies have the naugh­ti­est and the nicest account­ing.  Cit­i­group def­i­nitely makes my  naughty list.

Citi’s reported earn­ings over­stated its true eco­nomic earn­ings by $51.8 bil­lion (60% of rev­enues) in 2010. Over­stated earn­ings have also led to an over-priced stock and landed C on our most dan­ger­ous stocks list for May.

Investors should sell Citigroup, as well as any ETFs and mutual funds that hold it, before the over­stated earn­ings bub­ble pops. I think Citi is run­ning out of account­ing tricks that have stretched the chasm between earnings that pass muster with generally accepted accounting principles and what I define as true economic earnings.

The figure 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.

The rather large diver­gence between reported and eco­nomic earn­ings is made pos­si­ble by account­ing rule manip­u­la­tions, explained below.  Let me be clear that Citi is not break­ing any for­mal laws or rules. It is sim­ply play­ing the same earn­ings man­age­ment game that Wall Street has been play­ing for years. The dif­fer­ence now is that game is end­ing as Citi runs out of tricks to prop up its earnings.

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Late last August, I noted the abnormally-large 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 Citi was seri­ously stretch­ing account­ing rules by car­ry­ing such a large deferred tax asset. To jus­tify the $50 bil­lion 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. Some­how, Citi con­vinced its audi­tors it would achieve and sus­tain a rather epic turn­around in profits.

In 2010, it upped the ante and increased its deferred tax assets (“DTAs”) 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 cap­i­tal require­ments and bor­row­ing costs, Citi has a lot to lose if they had to write-down the DTAs.

$5.0 bil­lion of the increase in the deferred tax asset comes from recon­sol­i­dat­ing previously-off-balance-sheet assets due to an account­ing rule change (FAS 166/167). About half of the $5 bil­lion comes from the increase in Citi’s “tax credit and net oper­at­ing loss carry-forwards” to $23.3 bil­lion from $20.8 bil­lion in 2010 over 2009.

That increase comes despite Citi’s record­ing a 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 shot-2011-05-17-at-11.58.18-AM.png”>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 their stock price propped up. In this mat­ter, hav­ing the U.S. Trea­sury as one of your major share­hold­ers prob­a­bly does not hurt.

But wait, there is more buried in the foot­notes. Citi also under­states its pro­vi­sion for loan losses and boosts reported earn­ings by about $5.7 bil­lion, 7% of revenue.

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, I 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. There­fore, the level of reserves rises even though Citi recorded a pro­vi­sion for loan losses of $26.0 bil­lion ver­sus gross charge-offs of $34.5 bil­lion in 2010.

One could argue that these account­ing shenani­gans were not as big a deal if Citi’s stock was cheap, but that is not the case.

To jus­tify its cur­rent stock price of about $41, the com­pany must grow its after-tax prof­its (NOPAT) 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.

Citi gets my “very dan­ger­ous” rat­ing because the down­side risk dwarfs the upside poten­tial of the stock. I 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:

1. iShares Dow Jones US Finan­cial Ser­vices (IYG) – “dan­ger­ous” rat­ing with 8.7% allo­cated to Citigroup
2. KBW Bank ETF (KBE) – “very dan­ger­ous” rat­ing with 6.9% allo­cated to Citigroup
3. Select Sec­tor SPDR-Financial (XLF) – “dan­ger­ous” rat­ing with 6.5% allo­cated to Citigroup
4. Van­guard Finan­cials Index Fund (VFH) – “dan­ger­ous” rat­ing with 5.3% allo­cated to Citigroup

For more infor­ma­tion on our cov­er­age of ETFs, click here.

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