Stock Analysis

We Think Michael Hill International's (ASX:MHJ) Statutory Profit Might Understate Its Earnings Potential

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ASX:MHJ
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As a general rule, we think profitable companies are less risky than companies that lose money. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. In this article, we'll look at how useful this year's statutory profit is, when analysing Michael Hill International (ASX:MHJ).

While Michael Hill International was able to generate revenue of AU$492.1m in the last twelve months, we think its profit result of AU$3.06m was more important. Below, you can see that both its revenue and its profit have fallen over the last three years.

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ASX:MHJ Earnings and Revenue History January 15th 2021

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. Therefore, we think it's worth taking a closer look at Michael Hill International's cashflow, as well as examining the impact that unusual items have had on its reported 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.

A Closer Look At Michael Hill International's 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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Michael Hill International has an accrual ratio of -0.36 for the year to June 2020. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of AU$66m in the last year, which was a lot more than its statutory profit of AU$3.06m. Michael Hill International's free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

Michael Hill International's profit was reduced by unusual items worth AU$8.5m 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. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. 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. Michael Hill International took a rather significant hit from unusual items in the year to June 2020. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On Michael Hill International's Profit Performance

In conclusion, both Michael Hill International's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon Michael Hill International's statutory profit probably understates its earnings potential! So while earnings quality is important, it's equally important to consider the risks facing Michael Hill International at this point in time. Case in point: We've spotted 3 warning signs for Michael Hill International you should be aware of.

After our examination into the nature of Michael Hill International's 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. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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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