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A Dive into Reported Profits

Last month, Commonwealth Bank reported a record annual after-tax profit for the 2023 Financial Year of $10.1 billion. CBA’s profit result was viewed as controversial by some  Corporate earnings’ obscene’ as CBA posts record profit, say Greens. However, this specious analysis ignores the fact that the “large” headline profit number must be divided by the 1.67 billion CBA shares on issue.

Whilst large corporations generate large profits in dollar terms, what is often ignored in much of the debate on corporate profitability is that these profits must be shared amongst millions of individual shareholders. In this piece, we are going to look at different measures of corporate profitability for large Australian listed companies, looking beyond the billion-dollar headline figure, which frequently does not tell investors how efficiently management is running the business or how well they are using the capital given to them. This piece originally was published in Livewire.

Different Measures of Profitability

As a fund manager, the $10.1 billion of cash profit generated by Commonwealth Bank over the past twelve months does not mean very much. Investors should be most concerned with the underlying earnings per share (EPS), which is what the owner of a single share of the company receives from the profit generated in a particular year. In CBA’s case, their cash earnings per share in the 2023 financial year compared with last year grew 5.9% to $6.06 – nice growth but not particularly exciting.

We also look at growth in EPS, as often, a company’s profits can grow substantially when it makes an acquisition. However, if that acquisition is funded by issuing a large number of additional shares, profit per share might not actually grow. This has been the case with fund manager Perpetual, which has increased net profit over the past five years from A$116 million to A$163 million in 2023. However, earnings per share have declined from $2.46 to $1.97, as the increase in profit was derived from acquisitions funded by dilutive equity issuances.

Conversely, a company’s profits may be down, but if this is due to the selling of a non-core division, it could be a good result for shareholders. In 2019, Suncorp sold its smash repairs and life insurance businesses, with the proceeds recycled into a share buy-back and a special dividend. Suncorp has increased annual earnings per share by +15% despite selling two businesses since 2019.  

At a company level, we also look at measures such as returns and profit margins, which can be better measures of how efficient a company’s management team is at generating its annual profits. Furthermore, these measures allow the investor to compare companies in similar industries. For example, the profit margins of Coles and Woolworths or NAB and Westpac are compared on results day to evaluate how the different management teams are navigating the prevailing economic conditions.

Return on Capital Employed

 Return on Capital Employed (ROCE) looks at the profit generated by the equity holders’ capital to establish the business and the debt that is taken on to support the business activities. ROCE is calculated by dividing a company’s profit before interest and taxes by the shareholders’ equity plus debt. The investment by shareholders includes both original share capital from the IPO plus retained earnings. Retained earnings are the profits the company keeps in excess of dividends paid and are used to fund capital expenditure to maintain or grow the company. Companies with high ROCE typically require little in the way of equity to keep the business running, little need to borrow from their bankers and are generally seen as good investments.

The above chart shows the top and bottom companies in the ASX as ranked by ROCE. The top ROCE earners include a lithium company (PLS), three coal companies (Whitehaven, Coronado and New Hope), a healthcare company (Promedicus), as well as cloud-based software provider (Technology One). Qantas appears high on this list for FY2023 as the net equity position of the airline is a mere $5 million due to accumulated losses, share buy-backs, and net debt of $2.9 billion. We would not expect Qantas to feature as highly in future years as the company spends between $12 and $15 billion to update its fleet after years of underinvestment in aircraft.

The common factor in these businesses is high commodity prices, low or no debt and minimal ongoing capital expenditure to run the company. The three coal companies are in an interesting position. Typically, high commodity prices result in takeovers and significant capital expenditure to expand existing mines, both of which result in higher levels of debt and equity issuance that expand a company’s capital base. Due to difficulties in getting approvals to expand mines and concerns about banks in the future refusing to lend to coal companies, management teams had paid down debt. This places the companies in a net cash position. Additionally, the companies have conducted on-market buy-backs to shrink their capital base. This results in high return on capital positions for the three coal miners.

Bringing up the rear is a range of capital-heavy businesses that require both large amounts of initial capital to start the business and regular capital expenditure to maintain the quality of their assets and finance their ongoing activities. For the purposes of this analysis, Atlas has only included companies that generated a profit in FY2023. This subset includes food companies (Bega and United Malt Group), a construction company (Lend Lease), a telco (TPG) and an embattled casino company (Star Entertainment).

Typically, when looking at this measure, miners, steelmakers, wineries and Qantas are prominently featured amongst the lowest returning businesses as they are operating in capital-hungry industries. However, in 2023, these three industries are currently enjoying cyclically strong earnings. Return on capital employed is a measure not used to evaluate banks due to the sheer size of total assets on the bank balance sheet used to generate profits – in CBA’s case, 2023, $1.25 trillion.

Profit margin

Profit margin is calculated by dividing net profits by revenues. It measures the percentage of each dollar a company receives that results in profit that can be paid to shareholders. Typically, low-margin businesses operate in highly competitive mature industries. The absolute profit margin is not always what investors should look at when analysing a company’s results, but rather a change in this margin. A rising profit margin may indicate a company enjoying operating leverage as profits are growing faster than costs. Conversely, a declining profit margin could indicate stress and might point to large future declines in profits.

From the above chart that looks at the profit margins for ASX for the six months ending June 2023, the highest profit margins are generated by companies that are miners with operating mines enjoying high lithium and coal prices (PLS, IGO, Whitehaven and Lynas), royalty trust (Deterra), medical software (Pro Medicus) and energy company (Woodside).  

Mining and energy companies enjoy high profit margins, as once the large offshore LNG trains or mines are built and operating smoothly, these assets have a low marginal cost of production per barrel of oil or tonne of ore. This metric does not account for the tens of billions in capital required to build these giant projects. The highest margin company on the ASX 200 is Deterra Royalty Trust, which is somewhat of an anomaly in that it does not actually operate an iron ore mine in the Pilbara but rather collects a quarterly royalty payment of 1.23% of the value of iron ore sold by BHP mined in its royalty area.

Low-profit margin companies characteristically receive large revenues but operate in intensely competitive industries such as grocery retailing (Metcash), fast food (Dominos Food, Collins Food) labour intensive healthcare and engineering (Ramsay Health, Worley), and petrol retailing (Viva Energy). Toll road operator Transurban made the list in 2023, making a minuscule profit despite toll roads being very profitable and high-margin businesses. Typically, the company’s $1 billion non-cash depreciation and the small $100 million annual maintenance capex charge allow Transurban to avoid making a statutory profit yet deliver healthy free cash flows to pay distributions to shareholders.

Generally, companies with low profit margins are obviously forced to concentrate closely on preventing their profit margins from slipping, as a small change in their margins is likely to impact the profit available for distribution to shareholders significantly. 

Our take

While the banks and the large miners (BHP and RIO) generate large absolute profits, resulting in headlines around the billions of dollars they earn, they are generally not among the most profitable large listed Australian companies in terms of profit margins and returns on assets. Over the last six months, Commonwealth Bank’s 53,754 employees produced a $10.5 billion profit, representing a return on assets of 0.8% and a profit or net interest margin of only 2.07% on a loan book of $926 billion. When looking at companies to include in the Atlas Core Australian Equity Portfolio, the earnings power indicators are not the headline number but instead its return on capital, dividend and earnings per share growth as well as changes in profit margins.

August Monthly Newsletter

  • August saw most Australian companies release their financial reports for the first six months of 2023. The month showed that Australian listed companies are in better health than feared, with more companies beating expectations and guidance than missing. The dominant theme moving share prices over the month was issues in the Chinese property sector, a falling Australian dollar (-6%), and actual company financial results.
  • The Atlas High Income Property Fund pulled back by -3.8%, giving back July’s gains despite having a good earnings season based on rising inflation-linked rents, low vacancies, and long lease terms to quality tenants.
  • Portfolio companies, on average, increased dividends by +2% in the August reporting season, slightly ahead of the broader property index that was unchanged from August 2022. The key focus in reporting season was valuations and the perception that company valuations are stale and do not represent what a company could realise from selling its assets today. While this may be true for office towers and large shopping centres, it is not valid for companies the Fund holds selling assets over the past year at stated book value.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2024.

Earnings Chicanery Part 2

In the first instalment of Atlas’ surprisingly popular series on financial statement trickery written with the August reporting season in mind, we examined the three financial statements and some measures a company can take to “dress up” their financial results. In this week’s instalment, we will build on the previous earnings chicanery piece and look at some warning signs that there may be problems with a company’s financial statements.

Red Flag 1: the statements don’t match

On results day, most attention is focused on a company’s profit and loss statement. In particular, analysts and the financial press scrutinise whether the company achieved the expected profit or earnings per share guidance, usually given at the last result or an update like the company’s annual general meeting three to four months ago. Whilst the profit and loss statement usually provides good guidance as to how the company’s business has performed over the past six months, as discussed last week, it is also the statement most open to manipulation and should be read in conjunction with the cash flow statement. When Atlas looks at a company’s reported profits, we compare them to the operating cash flow. If there is a big divergence, then the accounts should be looked at carefully.

The red flag we are looking for here is when a company’s cash flow and profit and loss statements are moving in different directions over an 18-month period and where a company is showing growing profitability but declining cash flows. In the table below from the 2015 accounts, electrical retailer Dick Smith Holdings reported income growing from $19 million to $38 million, greeted with applause, yet operating cash flow fell from $52 million to -$4 million. This suggests that the sales generating profits reported on the profit and loss statement were pushing the company towards administration, which happened the following year. Insolvency investigators found questionable management decisions, such as holding 12 years’ worth of sale as inventory in private-label AA batteries!

Another recent example of this can be seen in the producer of Atlas CIO’s favourite libation – Lark Distilling. Last year the whisky company reported robust profit growth and record annual sales. However, the cash flow statement painted a different picture, one of a company in negative cash flow requiring equity raisings to remain solvent. This appears to have continued in 2023, with the distiller of Tasmania’s finest seeing their cash balance fall from $16M to $7M.

We recognise that some of this is due to the working capital nightmare of whisky and wine production and cellaring, where costs of distilling, storing in oak barrels and taxes are incurred upfront and revenue collected many years later. However, in all businesses growing profits and increasing negative cash flows indicate profit-less growth and invariably result in dilutive equity raisings or worse.

Not always bad if the statements don’t match

Some businesses’ earnings on the profit and loss statement can diverge from the cash flow statement. For example, a construction company such as Lend Lease or Downer might not physically be paid until July of the following year for work done on a railway or apartment high rise, with significant costs and cash outflows incurring in the current period. Here the profits at a point in time may be greater than the cashflows, though the lumpiness of the cash flows received from large individual contracts should even out over time. Though Downer may not be the best example after being the poster child for accounting irregularities over the past year, slashing profit guidance and restating past years’ profits, overstated by $30-40 million.

Red Flag 2: A company consistently reports extraordinary items

Extraordinary items are gains or losses included on a company’s income statement from unusual or infrequent events. Importantly, they are excluded from a company’s operating earnings. These items are excluded from earnings to give investors a more “normalised” view of how the company has performed over the period. For example, if an industrial company such as Boral books a $50 million gain from selling excess industrial land, including this profit would obscure information about how the company’s building materials businesses have performed over the past six months. 

While reporting extraordinary items can be valid and useful, investors should be wary or make adjustments to company earnings where a company has frequent (and almost always negative) extraordinary items they seek to exclude from their reported profits.

As a long-term observer of the Australian banks, almost every year, they put through a write-off of the software below the profit line. In my view, investing in banking software is a core part of their business model, and it seems curious that the institution is willing to take the productivity benefits in their normalised earnings whilst ignoring a portion of the costs needed to achieve these gains.

Red Flag 3: Significant divergence from comparable companies

The warning sign we are looking for here is when a company consistently has higher average profitability, revenue growth or better working capital management than their industry peers. Invariably when management is asked, they will give an answer that relates to management brilliance or superior controls. Still, realistically mature companies operating in the same industry tend to exhibit very similar characteristics. As such, their financial statements should, to some extent, correspond to the statements of companies operating in the same industry. For example, supermarkets such as Woolworths should have a similar cash conversion profile to Coles (operating cash flow divided by operating profits) and not dissimilar profit margins, as they are selling identical products to largely the same set of customers. Further, the major banks should exhibit similar bad debt charges on their mortgage books, though the overall bad debt charge could diverge if a particular bank was overly exposed to specific large corporate bankruptcies.

Hollow logs?

Occasionally management teams may be incentivised to under-report profits in any current period. This generally occurs when a company is under heightened union scrutiny due to wage negotiations with their employees, excessive government attention from perceived excessive profits, or expects a problem in the next year and wants to smooth their profits. For example, in the current environment of extremely low bad debts, a bank could be incentivised to boost its bad debt provisions aggressively. Increasing provisions would reduce current period profits, with excess provisions, if not required, could be written back later to boost future profits. This is potentially a politically astute move when politicians are getting extensive press coverage for calling out a company’s headline profits, as Commonwealth Bank found out on Wednesday; see AFR Corporate earnings’ obscene’ as CBA posts record profit, say Greens. What was ignored by politicians here was the divisor of 1.67 billion CBA shares on issue that saw earnings per share increase by only 8%.

Our Take

Earnings misrepresentation is difficult for investors to detect from the publicly available accounts, but when revealed can sometimes have extreme results for a company’s share prices. In my experience, this is more an art than a science, as the investor gets a sense that something is not right with the accounts rather than definitive proof of earnings manipulation. Normally actual manipulation generally only becomes obvious ex post facto after management has been removed or a company goes into administration.