Following the solid earnings report from Seven Principles AG (ETR:T3T1), the market responded by bidding up the stock price. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.
XTRA:T3T1 Earnings and Revenue History September 27th 2024
Zooming In On Seven Principles' 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. This ratio tells us how much of a company's profit is not backed by free cashflow.
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 June 2024, Seven Principles recorded an accrual ratio of -0.89. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of €3.7m, well over the €2.06m it reported in profit. Seven Principles shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).
While the accrual ratio might bode well, we also note that Seven Principles' profit was boosted by unusual items worth €886k in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. Seven Principles had a rather significant contribution from unusual items relative to its profit to June 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.
An Unusual Tax Situation
Moving on from the accrual ratio, we note that Seven Principles profited from a tax benefit which contributed €332k to profit. 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! We're sure the company was pleased with its tax benefit. 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. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.
Our Take On Seven Principles' Profit Performance
Summing up, Seven Principles' accrual ratio suggests that its statutory earnings are well matched by free cash flow while its unusual items and tax benefit is boosted profit in a way that may not be sustained. After taking into account all the aforementioned observations we think that Seven Principles' profits probably give a generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Seven Principles at this point in time. In terms of investment risks, we've identified 2 warning signs with Seven Principles, and understanding these should be part of your investment process.
Our examination of Seven Principles 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. 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 with significant insider holdings to be useful.
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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.
