We Think CEC International Holdings's (HKG:759) Statutory Profit Might Understate Its Earnings Potential

It might be old fashioned, but we really like to invest in companies that make a profit, each and every year. 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. This article will consider whether CEC International Holdings' (HKG:759) statutory profits are a good guide to its underlying earnings.

While CEC International Holdings was able to generate revenue of HK$1.96b in the last twelve months, we think its profit result of HK$12.3m was more important. The chart below shows that while revenue has fallen over the last three years, the company has moved from unprofitable to profitable.

See our latest analysis for CEC International Holdings

Importantly, statutory profits are not always the best tool for understanding a company's true earnings power, so it's well worth examining profits in a little more detail. Today, we'll discuss CEC International Holdings' free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of CEC International Holdings.

A Closer Look At CEC International Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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.

Over the twelve months to April 2020, CEC International Holdings recorded an accrual ratio of -0.46. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of HK$334m, well over the HK$12.3m it reported in profit. CEC International Holdings' free cash flow improved over the last year, which is generally good to see.

Our Take On CEC International Holdings' Profit Performance

Happily for shareholders, CEC International Holdings produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that CEC International Holdings' statutory profit actually understates its earnings potential! And it's also positive that the company showed enough improvement to book a profit this year, after losing money last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Be aware that CEC International Holdings is showing 2 warning signs in our investment analysis and 1 of those is a bit unpleasant...

This note has only looked at a single factor that sheds light on the nature of CEC International Holdings' profit. 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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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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