KKR Delivers Illusionary Profits for Years

When considering investing in a company, it is crucial  to begin by asking a fundamental question: “Is the company generating profit from its business?” The answer to this question is especially important for common shareholders as the data shows that stocks of companies that are not generating profit from their business tend to deliver lower returns and higher risk across time and market conditions.

The 2022 annual report from KKR & Co shows that the company continues a six year trend of reporting negative cash flow from operations, while reporting positive net income.  This troubling financial situation raises questions regarding KKR’s financial health.

Cash flow from operations indicates the amount of money received from its customers minus the amount of money it took to operate the business to deliver those services.  Logically, a business that spends more money to deliver services than it makes from customers is not sustainable in the long run.

In 2022, the cash that KKR received from its customers was $5.28 billion less than the cash it spent to run its business. This trend has persisted for years. See the chart below:

Despite reporting a negative trend of cash flow from operating activities over the past six years, KKR reported positive and growing net income for several years. However, this trend culminated in a significant drop in net income to negative $1.02 billion in 2022. See the chart below:

This contradiction between operating cash flow and net income can be attributed to accrual accounting convention, which permits the recording of revenue and expenses when they are earned or incurred, regardless of when the actual cash is received or paid.

So while KKR is not making money from selling services to their customers, the company is reporting an overall positive and growing net income on an accrual basis. To see the source of money to run its business, we need to look at the other aspects of the cash flow statement.

From the above chart, we can see that in 2022 alone, KKR brought in $22.06 billion from financing activities (primarily from the issuance of debt) to fund its short falls from operations and to finance its investing activities. This pattern has persisted for years. With this in mind, its positive net income values need to be taken with a grain of salt.

Illusion of Profit: This pattern of negative cash flow from operations while reporting positive net income, a phenomenon we referred to as the “illusion of profit,” is an early warning sign of downside risk as well as major failures in the past, such as the case of Lehman Brothers. For short periods of time, this may be an acceptable, but given that KKR has been losing money from operations for six years it raises serious questions about its financial health.

This is a red flag that investors should research in the annual report to see how the company explains this financial situation. Regardless of their explanation, it does elevate the company’s risk. Companies that participate in this form of financial tactics expose millions of common stockholders to high risk and low returns. Additionally, in the event of a bankruptcy filing, common shareholders are typically last in line to recoup their investments.

The number of companies identified by our system as having the Illusion of Profit problem has significantly increased over the years. The data shows that companies, as a group, with illusionary profit deliver significantly lower stock returns and higher risk across time and across market conditions.  It is essential to carefully assess a company’s financial health before investing in it and continuously monitor it afterward.