We think ALJ Regional Holdings (NASDAQ:ALJJ) earnings are a poor guide to profitability

Even though ALJ Regional Holdings, Inc. (NASDAQ:ALJJ) posted strong earnings recently, the stock didn’t react much. We decided to deepen our analysis and we believe that investors may be concerned about several worrying factors that we have discovered.

Check out our latest analysis for ALJ Regional Holdings

NasdaqGM: ALJJ Earnings and Revenue History August 19, 2022

A Closer Look at ALJ Regional Holdings Earnings

A key financial ratio used to measure a company’s ability to convert earnings into free cash flow (FCF) is the exercise ratio. To get the strike ratio, we first subtract FCF from earnings for a period and then divide that number by the average operating assets for the period. The ratio shows us how much a company’s profit exceeds its FCF.

This means that a negative accrual ratio is a good thing because it shows that the company is generating more free cash flow than its earnings suggest. This doesn’t mean that we should worry about a positive accumulation ratio, but it should be noted where the accumulation ratio is rather high. Notably, there is academic evidence that suggests a high exercise ratio is a bad sign for short-term profits, generally speaking.

In the twelve months to June 2022, ALJ Regional Holdings recorded a accrual ratio of 2.10. Typically, this bodes ill for future profitability. Namely, the company did not generate a single penny of free cash flow during this period. Although it reported a profit of $95.2 million, an examination of free cash flow indicates that it actually spent $44 million last year. We saw that FCF was $19 million a year ago, so ALJ Regional Holdings has at least been able to generate positive FCF in the past. That said, there is more to the story. The adjustment rate reflects the impact of unusual items on the statutory profit, at least in part. A silver lining for ALJ Regional Holdings shareholders is that its accrual ratio was significantly better last year, giving reason to believe it may revert to stronger cash conversion in the future. Therefore, some shareholders might seek a higher cash conversion in the current year.

To note: we always recommend that investors check the strength of the balance sheet. Click here to access our analysis of ALJ Regional Holdings’ balance sheet.

How do unusual items affect profits?

In addition to the remarkable accrual rate and surge in non-operating revenue, we can also see that ALJ Regional Holdings benefited from unusual items worth $111 million over the last twelve months. While we like to see increases in earnings, we tend to be a little more cautious when unusual items have made a big contribution. When we analyzed the numbers of thousands of publicly traded companies, we found that an increase in unusual items in any given year is often not repeated the following year. And, after all, that’s exactly what accounting terminology implies. We can see that the positive unusual items of ALJ Regional Holdings were quite large compared to its earnings for the year to June 2022. All things being equal, this would likely have the effect of making statutory earnings a bad indicator of the underlying earning capacity.

Our view on the earnings performance of ALJ Regional Holdings

ALJ Regional Holdings had a low accrual rate, but its earnings were boosted by unusual items. For all the reasons discussed above, we believe that at first glance, ALJ Regional Holdings’ statutory earnings could be considered low quality, as they are likely to give investors an overly positive image of the company. With this in mind, we would not consider investing in a stock unless we have a thorough understanding of the risks. When we did our research, we found 2 warning signs for ALJ Regional Holdings (1 cannot be ignored!) which we believe deserve your full attention.

Our review of ALJ Regional Holdings has focused on some factors that can make its earnings look better than they are. And, based on that, we’re somewhat skeptical. But there are many other ways to inform your opinion about a company. Some people consider a high return on equity to be a good sign of a quality company. Although it might take a bit of research on your behalf, you might find this free collection of companies offering a high return on equity, or this list of stocks that insiders buy to be useful.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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