Esprit Holdings (HKG:330) Strong Profits May Be Masking Some Underlying Issues

Esprit Holdings Limited's (HKG:330) healthy profit numbers didn't contain any surprises for investors. We believe that shareholders have noticed some concerning factors beyond the statutory profit numbers.

Check out our latest analysis for Esprit Holdings

Examining Cashflow Against Esprit 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. 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.

For the year to June 2021, Esprit Holdings had an accrual ratio of 1.72. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of HK$377m, in contrast to the aforementioned profit of HK$2.04b. We saw that FCF was HK$247m a year ago though, so Esprit Holdings has at least been able to generate positive FCF in the past. Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively. The good news for shareholders is that Esprit Holdings' 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Esprit Holdings.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, Esprit Holdings increased the number of shares on issue by 50% over the last twelve months by issuing new shares. That means its earnings are split among a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. You can see a chart of Esprit Holdings' EPS by clicking here.

How Is Dilution Impacting Esprit Holdings' Earnings Per Share? (EPS)

Three years ago, Esprit Holdings lost money. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

In the long term, if Esprit Holdings' earnings per share can increase, then the share price should too. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

Esprit Holdings' profit suffered from unusual items, which reduced profit by HK$1.6b 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. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. In the twelve months to June 2021, Esprit Holdings had a big unusual items expense. 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 Esprit Holdings' Profit Performance

Summing up, Esprit Holdings' unusual items suggest that its statutory earnings were temporarily depressed, and its accrual ratio indicates a lack of free cash flow relative to profit. On top of that, the dilution means that shareholders now own less of the company. Considering all this we'd argue Esprit Holdings' profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Esprit Holdings, you'd also look into what risks it is currently facing. While conducting our analysis, we found that Esprit Holdings has 2 warning signs and it would be unwise to ignore them.

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. 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.
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