Solid Earnings May Not Tell The Whole Story For Potbelly (NASDAQ:PBPB)

Potbelly Corporation (NASDAQ:PBPB) just released a solid earnings report, and the stock displayed some strength. Despite this, our analysis suggests that there are some factors weakening the foundations of those good profit numbers.

View our latest analysis for Potbelly

Zooming In On Potbelly'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. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. 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 September 2024, Potbelly recorded an accrual ratio of 1.69. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of US$229k during the period, falling well short of its reported profit of US$38.4m. Potbelly shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio. The good news for shareholders is that Potbelly'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.

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.

The Impact Of Unusual Items On Profit

Potbelly's profit suffered from unusual items, which reduced profit by US$4.8m in the last twelve months. 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. If Potbelly doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Potbelly received a tax benefit of US$30m. 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! The receipt of a tax benefit is obviously a good thing, on its own. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.

Our Take On Potbelly's Profit Performance

Summing up, Potbelly'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. For the reasons mentioned above, we think that a perfunctory glance at Potbelly's statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Potbelly at this point in time. At Simply Wall St, we found 2 warning signs for Potbelly and we think they deserve your attention.

Our examination of Potbelly 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. 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 with high insider ownership.

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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.