Broadly speaking, profitable businesses are less risky than unprofitable ones. That said, the current statutory profit is not always a good guide to a company’s underlying profitability. This article will consider whether NRG Energy‘s (NYSE:NRG) statutory profits are a good guide to its underlying earnings.
We like the fact that NRG Energy made a profit of US$4.12b on its revenue of US$9.82b, in the last year. The good news is that the company managed to grow its revenue over the last three years, and also move from loss-making to profitable.
Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. So today we’ll look at what NRG Energy’s cashflow, tax benefits and unusual items tell us about the quality of its earnings. 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 NRG Energy’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. This ratio tells us how much of a company’s profit is not backed by free cashflow.
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. While having an accrual ratio above zero is of little concern, we do think it’s worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.
Over the twelve months to December 2019, NRG Energy recorded an accrual ratio of 0.49. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of US$1.2b in the last year, which was a lot less than its statutory profit of US$4.12b. At this point we should mention that NRG Energy did manage to increase its free cash flow in the last twelve months However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio. The good news for shareholders is that NRG Energy’s accrual ratio was much better last year, so this year’s poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.
How Do Unusual Items Influence Profit?
NRG Energy’s profit suffered from unusual items, which reduced profit by US$180m in the last twelve months. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it’s surprising tha the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that’s hardly a surprise given these line items are considered unusual. If NRG Energy doesn’t see those unusual expenses repeat, then all else being equal we’d expect its profit to increase over the coming year.
An Unusual Tax Situation
Moving on from the accrual ratio, we note that NRG Energy profited from a tax benefit which contributed US$3.3b to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. Of course, prima facie it’s great to receive a tax benefit. 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. While we think it’s good that the company has booked a tax benefit, it does mean that there’s every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.
Our Take On NRG Energy’s Profit Performance
Summing up, NRG Energy’s unusual items suggest that its statutory earnings were temporarily depressed, while its tax benefit is having the opposite effect, and its accrual ratio indicates a lack of free cash flow relative to profit. Considering all this we’d argue NRG Energy’s profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it’s equally important to consider the risks facing NRG Energy at this point in time. For example, we’ve found that NRG Energy has 5 warning signs (2 are potentially serious!) that deserve your attention before going any further with your analysis.
Our examination of NRG Energy 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 are plenty of other ways to inform your opinion of a company. 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.
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