Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. That said, the current statutory profit is not always a good guide to a company’s underlying profitability. This article will consider whether Delta 9 Cannabis‘s (TSE:DN) statutory profits are a good guide to its underlying earnings.
While Delta 9 Cannabis was able to generate revenue of CA$31.8m in the last twelve months, we think its profit result of CA$13.7m was more important. The chart below shows that revenue has improved over the last three years, and, even better, the company has moved from unprofitable to profitable.
Importantly, statutory profits are not always the best tool for understanding a company’s true earnings power, so it’s well worth examining profits in a little more detail. Therefore, today we’ll take a look at Delta 9 Cannabis’s cashflow, share issues and unusual items with a view to better understanding the nature of its statutory earnings. 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.
Examining Cashflow Against Delta 9 Cannabis’s Earnings
One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. You could think of the accrual ratio from cashflow as the ‘non-FCF profit ratio’.
That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. While it’s not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. That’s because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.
Over the twelve months to December 2019, Delta 9 Cannabis recorded an accrual ratio of 1.09. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CA$13.7m, a look at free cash flow indicates it actually burnt through CA$26m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CA$26m, this year, indicates high risk. Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.
One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Delta 9 Cannabis issued 7.4% more new shares over the last year. As a result, its net income is now split between a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company’s profits, while the net income level gives us a better view of the company’s absolute size.
A Look At The Impact Of Delta 9 Cannabis’s Dilution on Its Earnings Per Share (EPS).
Delta 9 Cannabis was losing money three years ago. And even focusing only on the last twelve months, we don’t have a meaningful growth rate because it made a loss a year ago, too. What we do know is that while it’s great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn’t needed to issue shares. So you can see that the dilution has had a bit of an impact on shareholders. Therefore, the dilution is having a noteworthy influence on shareholder returns. And so, you can see quite clearly that dilution is influencing shareholder earnings.
In the long term, if Delta 9 Cannabis’s earnings per share can increase, then the share price should too. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company’s share price might grow.
How Do Unusual Items Influence Profit?
The fact that the company had unusual items boosting profit by CA$17m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. And, after all, that’s exactly what the accounting terminology implies. We can see that Delta 9 Cannabis’s positive unusual items were quite significant relative to its profit in the year to December 2019. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.
Our Take On Delta 9 Cannabis’s Profit Performance
Delta 9 Cannabis didn’t back up its earnings with free cashflow, but this isn’t too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. For all the reasons mentioned above, we think that, at a glance, Delta 9 Cannabis’s statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So if you’d like to dive deeper into this stock, it’s crucial to consider any risks it’s facing.
Our examination of Delta 9 Cannabis 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.