Broadly speaking, profitable businesses are less risky than unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it’s not always clear whether statutory profits are a good guide, going forward. Today we’ll focus on whether this year’s statutory profits are a good guide to understanding Electronic Arts (NASDAQ:EA).
It’s good to see that over the last twelve months Electronic Arts made a profit of US$2.83b on revenue of US$5.39b. One positive is that it has grown both its profit and its revenue, over the last few years.
Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Thus, we will today look at Electronic Arts’s cashflow relative to its earnings, and consider how a tax benefit has impacted its statutory profit. That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.
Zooming In On Electronic Arts’s Earnings
As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company’s free cash flow (FCF) matches its profit. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company’s average operating assets over that period. The ratio shows us how much a company’s profit exceeds its FCF.
Therefore, it’s actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. That is not intended to imply we should worry about a positive accrual ratio, but it’s worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
For the year to December 2019, Electronic Arts had an accrual ratio of 0.56. That means it didn’t generate anywhere near enough free cash flow to match its profit. Statistically speaking, that’s a real negative for future earnings. In fact, it had free cash flow of US$1.8b in the last year, which was a lot less than its statutory profit of US$2.83b. We note, however, that Electronic Arts grew its free cash flow over the last year. Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio. This would partially explain why the accrual ratio was so poor. One positive for Electronic Arts shareholders is that it’s accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.
An Unusual Tax Situation
Moving on from the accrual ratio, we note that Electronic Arts profited from a tax benefit which contributed US$1.5b to profit. It’s always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. The receipt of a tax benefit is obviously a good thing, on its own. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. So while we think it’s great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.
Our Take On Electronic Arts’s Profit Performance
This year, Electronic Arts couldn’t match its profit with cashflow. If the tax benefit is not repeated, then profit would drop next year, all else being equal. For all the reasons mentioned above, we think that, at a glance, Electronic Arts’s statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. Obviously, we love to consider the historical data to inform our opinion of a company. But it can be really valuable to consider what other analysts are forecasting. At Simply Wall St, we have analyst estimates which you can view by clicking here.
Our examination of Electronic Arts has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying to be useful.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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