Here’s Why We Don’t Think Atari’s (EPA:ATA) Statutory Earnings Reflect Its Underlying Earnings Potential

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. Today we’ll focus on whether this year’s statutory profits are a good guide to understanding Atari (EPA:ATA).

While Atari was able to generate revenue of €20.5m in the last twelve months, we think its profit result of €1.00m was more important. The chart below shows how it has grown revenue over the last three years, but that profit has declined.

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ENXTPA:ATA Income Statement, March 25th 2020
ENXTPA:ATA Income Statement, March 25th 2020

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 Atari’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.

A Closer Look At Atari’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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company’s average operating assets over that 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. To quote a 2014 paper by Lewellen and Resutek, “firms with higher accruals tend to be less profitable in the future”.

For the year to September 2019, Atari had an accrual ratio of 0.43. Statistically speaking, that’s a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of €1.00m, a look at free cash flow indicates it actually burnt through €6.9m in the last year. We also note that Atari’s free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of €6.9m. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

The Impact Of Unusual Items On Profit

Atari’s profit suffered from unusual items, which reduced profit by €600k in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it’s not great to see in combination with an uninspiring accrual ratio. 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 that’s hardly a surprise given these line items are considered unusual. Atari took a rather significant hit from unusual items in the year to September 2019. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Atari profited from a tax benefit which contributed €800k to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! We’re sure the company was pleased with its tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. 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 Atari’s Profit Performance

Summing up, Atari’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 Atari’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 Atari at this point in time. For example, Atari has 4 warning signs (and 1 which is a bit concerning) we think you should know about.

Our examination of Atari 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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

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