As a general rule, we think profitable companies are less risky than companies that lose money. 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. In this article, we'll look at how useful this year's statutory profit is, when analysing Hutchison Telecommunications (Australia) (ASX:HTA).
While Hutchison Telecommunications (Australia) was able to generate revenue of AU$3.72m in the last twelve months, we think its profit result of AU$736.2m was more important. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.
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. So today we'll look at what Hutchison Telecommunications (Australia)'s cashflow and unusual items tell us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hutchison Telecommunications (Australia).
A Closer Look At Hutchison Telecommunications (Australia)'s Earnings
One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.
That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.
For the year to June 2020, Hutchison Telecommunications (Australia) had an accrual ratio of 1.51. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. To wit, it produced free cash flow of AU$2.8m during the period, falling well short of its reported profit of AU$736.2m. Hutchison Telecommunications (Australia) shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. The good news for shareholders is that Hutchison Telecommunications (Australia)'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?
The fact that the company had unusual items boosting profit by AU$677m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that Hutchison Telecommunications (Australia)'s positive unusual items were quite significant relative to its profit in the year to June 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.
Our Take On Hutchison Telecommunications (Australia)'s Profit Performance
Summing up, Hutchison Telecommunications (Australia) received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For all the reasons mentioned above, we think that, at a glance, Hutchison Telecommunications (Australia)'s statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Be aware that Hutchison Telecommunications (Australia) is showing 2 warning signs in our investment analysis and 1 of those doesn't sit too well with us...
In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. But there are plenty of other ways to inform your opinion of a company. 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. 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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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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