We Wouldn't Rely On Kathmandu Holdings's (NZSE:KMD) Statutory Earnings As A Guide

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. 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 Kathmandu Holdings' (NZSE:KMD) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Kathmandu Holdings made a profit of NZ$8.15m on revenue of NZ$801.5m. At the risk of seeming quaint, we do like to at least examine profit, even when a stock is improving revenue and considered a 'growth stock'. As you can see in the chart below, its profit has declined over the last three years, even though its revenue has increased.

View our latest analysis for Kathmandu Holdings

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. Therefore, today we'll take a look at Kathmandu Holdings' cashflow, share issues and unusual items with a view to better understanding the nature of its statutory 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.

Zooming In On Kathmandu Holdings' 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). 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. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to July 2020, Kathmandu Holdings recorded an accrual ratio of -0.23. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of NZ$150m during the period, dwarfing its reported profit of NZ$8.15m. Kathmandu Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Kathmandu Holdings issued 141% more new shares over the last year. As a result, its net income is now split between 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. Check out Kathmandu Holdings' historical EPS growth by clicking on this link.

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

Kathmandu Holdings' net profit dropped by 79% per year over the last three years. And even focusing only on the last twelve months, we see profit is down 86%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 90% in the same period. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

If Kathmandu Holdings' 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.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Kathmandu Holdings' profit was boosted by unusual items worth NZ$15m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that Kathmandu Holdings' positive unusual items were quite significant relative to its profit in the year to July 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Kathmandu Holdings' Profit Performance

Summing up, Kathmandu Holdings' accrual ratio suggests that its statutory earnings are well matched by cash flow while its unusual items boosted the profit in a way that might not be repeated. Further, the dilution means profits are now split more ways. Considering all this we'd argue Kathmandu Holdings' profits probably give an overly 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. Be aware that Kathmandu Holdings is showing 3 warning signs in our investment analysis and 1 of those shouldn't be ignored...

Our examination of Kathmandu Holdings 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.

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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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