Profitability And Creditworthiness Analysis For The Southwest Airlines

Profitability and Creditworthiness Analysis for the Southwest Airlines (LUV Ð'- NYSE symbol) :

Various financial ratios are used by managers and investors to analyze company's financial health. In this section we describe return on equity analysis to measure the Southwest's performance. ROE is viewed as one of the most important financial ratios. It is used in an effort to evaluate management's ability to monitor and control expenses and to earn a profit on resources committed to the business. Three levels of ROE ratios assess Southwest Airlines' strengths and weaknesses, operating results and growth potential. These ratios are used to measure how efficiently the assets are being used to generate net income and sales. The ratios also allow comparison of the profitability of Southwest Airlines to that of similar airlines within the industry. Southwest Airlines is known for their cost- cutting ideology. One of Southwest's primary competitive strengths is its low operating costs. Southwest has the lowest costs, adjusted for stage length, on a seat mile basis, of all the major airlines. Among the factors that contribute to its low cost structure are a single aircraft. Other major discount airlines, such as JetBlue (JBLU), AirTran (AAI) and SkyWest (SKYW) are also in the mix, and represent some serious competition. Through out the analysis the company is to be compared to Skywest airlines, the airlines industry, and the S&P500 index .

Southwest Airlines' ROE has fallen each period over the past four years, from a high in 2003 of 9.07% to 7.60% in 2006. ROE for the trailing 12 months (TTM) ending December 31,2006 was 7.60% and it is more incline with the last year ROE . Comparatively to the industry it is well below the mark, but the company has done better than its main competitor JetBlue (JBLU) due to the high asset turnover and profit margin. Nevertheless, the company's averaged five-year ROE rate of 6.99% exceeds the industry average which is -0.23 but certainly below an average S&P500 company where the rate is 18.18%.

% Company Industry S&P 500

Return on Equity 7.60 21.83 20.29

Return on Equity-5 Yr. Avg. 6.99 -0.23 18.18

Net income has grown steadily since 2003 from 442 to 499 million. Yet growth in average stockholder equity from 5052 million to 6449 million has been surpassing net income, which accounts for the Southwest Airlines' declining ROE. According to the Company's 2006 10-k report - "Although the airline industry as a whole in 2006 was expected to report its first collective profit since 2000, Southwest's string of consecutive profitable years has now reached 34, and the Company also extended its number of consecutive profitable quarters to 63, both of which are unmatched in the industry."

The company's ROE is above the 1st quartile of the all publicly traded U.S. companies. The two main drivers of ROE are the return on net operating assets (RNOA) and the return from nonoperating activities (FLEV * Spread). The company's RNOA has grown steadily since 2003 from 4.75% to 7.60%. RNOA has comprised 96% of the company's 2006 ROE which is way above the 75th percentile of the all publicly traded U.S. companies. The Company uses financial leverage and demonstrates significant improvement in reducing the financial leverage which has been decreasing over the years from 0.34 to 0.27. Also, the company generated a positive spread of 1.35% on borrowed monies in 2006. Overall the Southwest has maintained a strong balance sheet and an "A" credit rating on its senior unsecured fixed-rate debt with Standard & Poor's and Fitch ratings agencies, and a "Baa1" credit rating with Moody's rating agency as of December, 2006. (Credit Rating "A" represents above-average creditworthiness and "Baa1" represents average creditworthiness)

Level 2 ROE analysis focuses on the disaggregation of RNOA into its two basic components profit margin and asset turnover. Net operating profit margin reflects the percentage of each revenue dollar the company is realizing in after-tax operating profit and Net operating asset turnover reflects the productivity of assets. At the end of fiscal year 2006, the Southwest Airlines' RNOA was comprised of net operating profit margin (NOPM) of 6.49% and a net operating asset turnover (NOAT) of 1.12. Over the course of the four years analyzed, the company's NOPM increased from 5.08% to 6.49%. This is due to the net operating profit after tax (NOPAT) has been increased significantly since 2003. Net operating profit margin effect derive from the company's 2004 annual report as: "[(NOPM) decline was] primarily due to an increase in jet fuel prices, net of hedging gains, and an increase in salaries and wages, and benefits." ."Southwest's 2006 operating income was $934 million, an increase of $209 million, or 28.8 percent, compared to 2005. The Company modestly raised its fares over the course of the year, resulting in an increase in passenger revenue yield per revenue passenger miles (RPM = passenger revenues divided by revenue passenger miles) of 6.9 percent compared to 2005. Unit revenue (total revenue divided by available seat miles) also increased a healthy 10.2 percent compared to 2005 levels, as a result of the higher load factor and higher RPM yield." The 2004 NOPAT decline was due to the aftermath of the Iraq war.

% Company

(LUV) Competitor (SKYW) Industry S&P 500

Net Profit Margin 6.49% 4.68 3.00 13.43

Net operating profit margin (NOPAT), the higher the ratio for asset turnover, the more effective the company is using its assets to produce sales. It appears that Southwest is reasonably using their assets. They do not have excess turnover, which would signal the company is strapped for cash, and their turnover is not too low which would mean they have a shortage of cash and other assets. It appears that Southwest has remained relatively stable over the past five years. NOAT increased from 0.94 in fiscal year 2003 to 1.12 in fiscal year 2006. The company's average NOAT exceeds the industry average of 0.91 and the S&P 500 of 0.97.