Earnings Troubles May Signal Larger Issues for Semler Scientific (NASDAQ:SMLR) Shareholders

A lackluster earnings announcement from Semler Scientific, Inc. (NASDAQ:SMLR) last week didn't sink the stock price. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

See our latest analysis for Semler Scientific

A Closer Look At Semler Scientific's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Semler Scientific has an accrual ratio of 1.43 for the year to June 2024. 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 US$40m, in contrast to the aforementioned profit of US$15.8m. We saw that FCF was US$20m a year ago though, so Semler Scientific 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 Semler Scientific'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. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Semler Scientific issued 6.3% more new shares over the last year. As a result, its net income is now split between 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 Semler Scientific's historical EPS growth by clicking on this link.

A Look At The Impact Of Semler Scientific's Dilution On Its Earnings Per Share (EPS)

Unfortunately, Semler Scientific's profit is down 28% per year over three years. Even looking at the last year, profit was still down 11%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 13% in the same period. Therefore, the dilution is having a noteworthy influence on shareholder returns.

In the long term, if Semler Scientific's 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 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.

The Impact Of Unusual Items On Profit

Semler Scientific's profit suffered from unusual items, which reduced profit by US$6.1m 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. Assuming those unusual expenses don't come up again, we'd therefore expect Semler Scientific to produce a higher profit next year, all else being equal.

Our Take On Semler Scientific's Profit Performance

Summing up, Semler Scientific's unusual items suggest that its statutory earnings were temporarily depressed, and its accrual ratio indicates a lack of free cash flow relative to profit. And the dilution means that per-share results are weaker than the bottom line might imply. Based on these factors, we think that Semler Scientific's statutory profits probably make it seem better than it is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Semler Scientific at this point in time. Be aware that Semler Scientific is showing 3 warning signs in our investment analysis and 1 of those is a bit concerning...

Our examination of Semler Scientific 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. 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.