Solstad Offshore (OB:SOFF) Strong Profits May Be Masking Some Underlying Issues

Solstad Offshore ASA's (OB:SOFF) robust recent earnings didn't do much to move the stock. We believe that shareholders have noticed some concerning factors beyond the statutory profit numbers.

Check out our latest analysis for Solstad Offshore

A Closer Look At Solstad Offshore's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 December 2020, Solstad Offshore recorded an accrual ratio of 0.33. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Indeed, in the last twelve months it reported free cash flow of kr312m, which is significantly less than its profit of kr7.22b. Solstad Offshore's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. However, that's not the end of the story. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares. The good news for shareholders is that Solstad Offshore'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.

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

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Solstad Offshore expanded the number of shares on issue by 25,595% over the last year. That means its earnings are split among a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Solstad Offshore's historical EPS growth by clicking on this link.

How Is Dilution Impacting Solstad Offshore's Earnings Per Share? (EPS)

Three years ago, Solstad Offshore lost money. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, if Solstad Offshore's earnings per share can increase, then the share price should too. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Solstad Offshore saw its profit reduced by unusual items worth kr1.9b. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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. Solstad Offshore took a rather significant hit from unusual items in the year to December 2020. 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 Solstad Offshore's Profit Performance

In conclusion, Solstad Offshore's accrual ratio suggests that its statutory earnings are not backed by cash flow; but the fact unusual items actually weighed on profit may create upside if those unusual items to not recur. On top of that, the dilution means that shareholders now own less of the company. After taking into account all the aforementioned observations we think that Solstad Offshore's profits probably give a generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To help with this, we've discovered 5 warning signs (3 are a bit unpleasant!) that you ought to be aware of before buying any shares in Solstad Offshore.

Our examination of Solstad Offshore 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 is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. 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.

If you decide to trade Solstad Offshore, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.