Weak Statutory Earnings May Not Tell The Whole Story For H&K (EPA:MLHK)

The subdued market reaction suggests that H&K AG's (EPA:MLHK) recent earnings didn't contain any surprises. We think that investors are worried about some weaknesses underlying the earnings.

View our latest analysis for H&K

A Closer Look At H&K'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. 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. 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.

For the year to December 2023, H&K had an accrual ratio of 0.20. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of €19.2m, a look at free cash flow indicates it actually burnt through €14m in the last year. It's worth noting that H&K generated positive FCF of €35m a year ago, so at least they've done it in the past. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of H&K.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. As it happens, H&K issued 28% more new shares over the last year. That means its earnings are split among a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of H&K's EPS by clicking here.

How Is Dilution Impacting H&K's Earnings Per Share (EPS)?

As you can see above, H&K has been growing its net income over the last few years, with an annualized gain of 42% over three years. But EPS was only up 21% per year, in the exact same period. Net income was down 62% over the last twelve months. But the EPS result was even worse, with the company recording a decline of 68%. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

If H&K's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On H&K's Profit Performance

As it turns out, H&K couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). Considering all this we'd argue H&K's profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Our analysis shows 5 warning signs for H&K (2 shouldn't be ignored!) and we strongly recommend you look at these bad boys before investing.

Our examination of H&K 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. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.