Here's Why We Think James Hardie Industries's (ASX:JHX) Statutory Earnings Might Be Conservative

As a general rule, we think profitable companies are less risky than companies that lose money. That said, the current statutory profit is not always a good guide to a company's underlying profitability. In this article, we'll look at how useful this year's statutory profit is, when analysing James Hardie Industries (ASX:JHX).

While James Hardie Industries was able to generate revenue of US$2.65b in the last twelve months, we think its profit result of US$148.1m was more important. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

See our latest analysis for James Hardie Industries

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. So today we'll look at what James Hardie Industries' cashflow 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.

A Closer Look At James Hardie Industries' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2020, James Hardie Industries had an accrual ratio of -0.16. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of US$491m, well over the US$148.1m it reported in profit. James Hardie Industries shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

How Do Unusual Items Influence Profit?

James Hardie Industries' profit was reduced by unusual items worth US$93m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect James Hardie Industries to produce a higher profit next year, all else being equal.

Our Take On James Hardie Industries' Profit Performance

Considering both James Hardie Industries' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think James Hardie Industries' earnings potential is at least as good as it seems, and maybe even better! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. While conducting our analysis, we found that James Hardie Industries has 3 warning signs and it would be unwise to ignore them.

After our examination into the nature of James Hardie Industries' profit, we've come away optimistic for the company. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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