Shareholders Shouldn’t Be Too Comfortable With Telos' (NASDAQ:TLS) Strong Earnings

Telos Corporation's (NASDAQ:TLS) stock rose after it released a robust earnings report. While the headline numbers were strong, we found some underlying problems once we started looking at what drove earnings.

See our latest analysis for Telos

Examining Cashflow Against Telos' 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). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 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. 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 December 2020, Telos had an accrual ratio of 0.62. 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$9.6m, in contrast to the aforementioned profit of US$1.69m. We saw that FCF was US$5.3m a year ago though, so Telos has at least been able to generate positive FCF in the past. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio). One positive for Telos shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. 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.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Telos' profit was boosted by unusual items worth US$14m 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. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. We can see that Telos' positive unusual items were quite significant relative to its profit in the year to December 2020. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Telos profited from a tax benefit which contributed US$46k to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. Of course, prima facie it's great to receive a tax benefit. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. 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 Telos' Profit Performance

Summing up, Telos' tax benefit and unusual items boosted its statutory profit leading to poor cash conversion, as reflected by its accrual ratio. For all the reasons mentioned above, we think that, at a glance, Telos' statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. To help with this, we've discovered 2 warning signs (1 is a bit unpleasant!) that you ought to be aware of before buying any shares in Telos.

Our examination of Telos 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. 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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