Here's Why NETGEAR's (NASDAQ:NTGR) Statutory Earnings Are Arguably Too Conservative

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. Today we'll focus on whether this year's statutory profits are a good guide to understanding NETGEAR (NASDAQ:NTGR).

We like the fact that NETGEAR made a profit of US$26.9m on its revenue of US$1.14b, in the last year.

See our latest analysis for NETGEAR

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. As a result, today we're going to take a closer look at NETGEAR's cashflow, and unusual items, with a view to understanding what these might tell us about its statutory profit. 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.

A Closer Look At NETGEAR's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. 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.

NETGEAR has an accrual ratio of -0.38 for the year to September 2020. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of US$176m in the last year, which was a lot more than its statutory profit of US$26.9m. Given that NETGEAR had negative free cash flow in the prior corresponding period, the trailing twelve month resul of US$176m would seem to be a step in the right direction. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

How Do Unusual Items Influence Profit?

NETGEAR's profit was reduced by unusual items worth US$7.8m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. 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 that's hardly a surprise given these line items are considered unusual. If NETGEAR doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On NETGEAR's Profit Performance

In conclusion, both NETGEAR's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think NETGEAR's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! If you want to do dive deeper into NETGEAR, you'd also look into what risks it is currently facing. Case in point: We've spotted 1 warning sign for NETGEAR you should be aware of.

Our examination of NETGEAR has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there are plenty of other ways to inform your opinion of a company. 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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