How to work out a company's real profitability

I will consider some possible approaches to this issue and then take you through a practical example with a real company to show you how you can get an estimate of a company’s true underlying profitability.

What you are trying to achieve

The goal is to obtain a realistic and prudent estimate of how much money a company is making from its trading activities. The estimate needs to reflect the business in a steady state and not penalise a business for investing for growth (spending money on new assets and working capital). The estimate will allow you to gain a clearer understanding of how a business is performing.

By matching revenues and costs, this is what accounting profits are designed to tell you. As last week’s column highlighted, the main problem with accounting profits comes with interpreting which costs are regular ongoing ones and which are exceptional or one-off.

Should investors just look at reported profits instead of adjusted ones?

You should always look at reported profits. However, they do sometimes include costs that are one-off and are not related to the underlying trading activities of a business. These costs can often give you valuable insights into a business and should not be ignored.

The problem with free cash flow

I’m a big fan of using cash flows to evaluate a business. First and foremost, you want to see a company convert its profits into cash and have plenty of surplus or free cash flows that can grow over time. Free cash flow does, however, have the potential to present a misleading picture of a company’s health and performance.

Working capital cash flows reflect the timing of payments to and from a company. Large working capital inflows caused by a company delaying the payments of its suppliers (a cost) should not be seen as a permanent source of value. Nor should an increase in trade debtors – which can increase profitable sales – and the cash outflow that results from it be seen in a negative light.

Boosting free cash flow by underinvesting can actually make a company less rather than more valuable. That said, an analysis of cash flows is extremely helpful to anyone trying to work out a company’s true profitability. As we shall see, cash flow analysis is great at identifying items such as pensions, provisions and capex that can distort profits.

Many companies’ profits are true and clean

Despite my issues and concerns with how some companies present their profits to investors, there are some shining examples of exemplary reporting.

One of the best examples I have come across is Alternative Investment Market (Aim)-traded flooring company James Halstead (JHD). This is a high-quality business in many respects and extends this to the way it reports its profits. Looking back over the past 10 years, the company has not made any adjustments to its reported profits. It does not capitalise research and development costs and is very good at highlighting one-off costs (such as product launch expenses) without adjusting for them.

It prides itself on taking a prudent approach to reporting its profits. An example that many companies would do well to copy, in my opinion. The company’s approach is highlighted in its latest annual report (below).

But when you come across a company that makes a lot of profit adjustments, you need to ask whether they are justified and try to work out what’s really going on.

What are FirstGroup’s real operating profits?

Bus and rail operator FirstGroup is a very good example of a company where there has regularly been a difference between its reported and adjusted operating profits.

FirstGroup adjusted profits

Source: 2018 Annual Report

In the year to March 2018, the company made a reported operating loss of £196.2m due to lots of exceptional costs that are highlighted below. If these costs are ignored, then it made an operating profit of £317m - a big difference.

FirstGroup’s adjusted operating profits are generally quite a bit higher than its reported operating profits.

FirstGroup operating profit

Source: Annual reports

What is an investor to make of all these adjustments?

We are going to look at them in turn and look at how an investor might interpret them in working out an estimate of the company’s real underlying operating profits. As well as these items, we will also consider the company’s pension and depreciation expenses and consider whether adjustments need to be made to them. At the end of the exercise, we will have an estimate of FirstGroup’s profits that can be compared with its adjusted operating figure.

Other intangible asset amortisation charges of £70.9m

FirstGroup is asking the investor to ignore this expense. The bulk of the amortisation expense is related to customer contracts (£53.5m), which have arisen as part of the cost of previous acquisitions and are treated as an intangible asset along with other items such as goodwill. There is no annual cash expense being made to maintain this intangible asset. It therefore seems reasonable to add back the £53.5m to reported operating loss.

However, £14.1m of intangible amortisation relates to software. This is a genuine cash cost as evidenced by the £26.8m spent on new software assets during the year. The company explains what its software assets are in its accounts.

I therefore think that the £14.1m amortisation expense should not be ignored. Of the £70.9m of intangible asset amortisation, £56.8m can be added back to the reported loss in our process of estimating FirstGroup’s real operating profits.

Greyhound impairment charges of £277.3m

The poor profitability of Greyhound has seen its balance sheet value reviewed. In the opinion of the company’s directors, the present value of Greyhound’s future cash flows was £277.3m less than its balance sheet value. Most of this reduction is related to goodwill.

Impairment of tangible fixed assets can boost future profits (but not cash flows) by reducing future depreciation expenses. As the impairment of tangible fixed assets in this case is very small, any future profit boost is not really significant.

It is reasonable to ignore this impairment charge and add back the £277.3m to our profit estimate.

TPE onerous contract provision of £106.3m

The company’s Trans-Pennine Express (TPE) rail franchise is not making as much money as it was expected to do. It is expected to be lossmaking until the franchise ends in 2023. The estimated losses are £106.3m and the company has created a provision for these as an onerous contract.

What this means in practice is that the expected future losses have been recognised in full, upfront. When the losses actually occur, the company will use the provision to offset them in its accounts. For example, if the loss from TPE is £20m in 2019, £20m of the £106.3m provision will be used to offset it so that profits are not reduced (as they have already) even though cash will flow out of the business.

If the company does not exclude the benefit of the provision utilisation from its adjusted profits in the years 2019-23 then this provision has the potential to flatter them.

Investors also need to be aware that the provision for losses could change depending on how the franchise performs in terms of passenger revenues. They should not ignore the risk that losses could increase and realise that the losses are a real loss of value for shareholders going forward, despite them being treated as an exceptional item.

However, as far as estimating real underlying profits in 2018 is concerned, the provision can be added back.

Restructuring costs of £26.0m

Struggling businesses often incur significant restructuring costs in order to clean them up and put them on a sounder footing. We can see that not only is the expense quite a large number but that there was another restructuring expense last year.

These costs are supposed to be one-offs. If they occur every year then they are obviously not. Looking back over the past five years sees minimal restructuring costs between 2014 and 2016. I am going to give FirstGroup the benefit of the doubt here and add back the restructuring costs.

North America insurance reserves of £32.7m

FirstGroup self insures a large proportion of its US bus operations. The cost of this self insurance is reflected in a provision on the company’s balance sheet. The company makes an estimate of the likely cost of insurance claims, which are added to the provision balance each year and reduce its profits. When the cash is spent on the cost of claims, the provision balance is reduced.

FirstGroup says that the estimate of insurance claims are likely to be paid during a period of up to six years, but the bulk of the cash spent each year relates to the current portion (due in one year or less) of the provision.

Provisions used to be a great source of profit manipulation. The scope for abuse has been reduced over the years from the introduction of updated accounting standards. That said, there is a chance that a company could underestimate its likely insurance claims and flatter its profits.

Over the past six years, FirstGroup has spent nearly £100m more in cash than it has expensed against its revenues. It is difficult to know whether this is a sign of aggressive accounting or just a reflection of timings and the size and nature of its bus fleet. A small amount of costs can also be claimed from insurance companies, which is shown as a debtor on the balance sheets.

FirstGroup Insurance Provision

Source: Annual reports

That said, the £32.7m of insurance reserves relate back to the estimates made back in 2014 and 2016 and represent the increase in costs compared with them. What this means in retrospect is that FirstGroup’s estimates back then were too low based on the actual outcome and that its profits were too high.

The treatment of the £32.7m as an exceptional item is slightly contentious in my view. Yes, it doesn’t relate to 2018 costs, but it does raise the issue that the large insurance expense has the potential to flatter profits.

That said, it’s difficult to know how to treat this item. I will be generous and add it back, but note that it is potentially a grey area in terms of profit quality.

Additional pension costs

FirstGroup has a large final-salary pension fund deficit. In order to plug the deficit, it has to make top-up payments over and above the regular cost expensed in the income statement. You can argue with my approach, but if you want a prudent estimate of a company’s real operating profits then this extra cash cost needs to be taken into account and profits reduced by it.

FirstGroup pension deficit

Source: Annual reports

As you can see, FirstGroup has regularly paid more cash into its final-salary scheme than it has expensed as a regular cost in its income statement. You can find this number in the operating cash flow note in a company’s accounts.

The additional cash payment was £47.9m in 2018 which is a big proportion of adjusted operating profits. Top-up payments can be lumpy and need to be adjusted for. My rough rule of thumb is to take the deficit on the balance sheet data and divide it by 10 in order to assume the deficit is plugged over 10 years.

Applying this rule lowers the estimate of FirstGroup underlying operating profit by £30.6m in 2018.

How much does it cost to stay in business?

When Warren Buffett is trying to work out what he calls a company’s “owner earnings” he tries to estimate how much it needs to spend on maintaining its assets in good condition in order to stay in business and generate its revenues. He calls this “stay-in-business capex” and is often referred to by companies as 'maintenance' or 'replacement' capex.

Unless the company gives you this number (companies such as Whitbread do) it can be very difficult to know what it is. Depreciation can be a good starting point and is seen as a proxy for replacement capex.

FirstGroup depreciation

Source: Annual reports

Often, depreciation understates stay-in-business capex, particularly for a company with old assets. There’s a case for arguing that FirstGroup’s depreciation also understates it following a period of low investment a few years ago, but not by much.

Depreciation has been rising significantly in recent years. That said, to be prudent, I will take away the additional £19m of cash capex over depreciation spent in 2018 from estimated profits.

This leaves me with an estimate of underlying operating profits of £253.2m compared with the company’s adjusted figure of £317m.

The difference is significant. You may disagree with my final number, but hopefully you will agree that this exercise is extremely useful and informative to potential investors. In addition to some adjustments, key issues of profit quality to do with restructuring and insurance provisions as well as pensions have also been identified.