The Financial Analysis of Southwest Airlines - Admission/Application Essay Example

Financial Analysis Table of Contents Introduction 1 Financial performance 3 Stock performance 7 Future projection of Southwest Airlines 10 Conclusion 11 Reference 13 Introduction The market conditions are changing at a fast rate; this has resulted into a great degree of uncertainty regarding the market conditions in nearby future. Due to changes in the external environmental conditions, performance of the companies often gets directly affected. To minimise the risk of uncertainly, companies often opt for forward or backward integration. The concept of entering into agreements is also common; long-term agreements are being done between the suppliers and their respective customers. This assists both the companies to minimise the risk of fluctuation in demand, supply and prices. The companies also share technical knowledge and experience with each other to gain synergy. Once the companies enter into a contract, they have to adhere to the terms and conditions mentioned in the contract. Even if they try to cancel the contract, it becomes a tedious task. A wrong agreement may cost the company immensely; due to which the financial as well as market position of the company may get effected. Therefore, before entering into a contract, the company should analyse the potential of the company with which contract will be signed. RenDi, a renewable synthetic diesel fuel manufacturer, is planning to enter into a five year agreement with Southwest Airlines (LUV). The synthetic diesel fuel will soon have good demand for ground support equipment (GSE) used in airline industry. Therefore, this agreement will be beneficial for both the companies. RenDi is planning to bear the cost of converting Southwest Airlines’ GSE to renewable fuel. As the conversion will be a costly process, so if this agreement fails, RenDi will suffer adversely. Therefore, before entering into the agreement, the financial condition of Southwest Airlines will be evaluated to find out whether Southwest Airlines possesses the potential to commit to the agreement for five years. While evaluating the financial potential of Southwest Airlines, at first the financial condition will be analysed with the help of different financial ratios. The financial performance of the company will also be compared with the performance of regional aviation industry. To evaluate the market (stock) performance of Southwest, historical stock price movements as well as the risk associated with the share price will be taken into consideration. Finally, future projections about the financial position of Southwest Airlines will be done. While developing the future outlook, prediction of different market analysts, about the market condition, will be taken into consideration. Financial performance Southwest Airlines is an American low cost airline that is listed on the New York Stock Exchange (NYSE). In the year 2009, the number of passengers who travelled through this airline was 101,338, thousands (IATA, “Scheduled Passengers Carried”). Thus Southwest Airlines ranked first among all international as well as domestic airlines in terms of ‘number of passengers travelled.’ The company also possesses large number of passenger fleets. This airline is considered as one of the most profitable airlines in the world (Reed, “Southwest Airlines Posts Profit”). An assessment of the financial information provided by the company in 10K form for the past three years shows that in 2008 company’s revenue increased by 11.78 percent. However, due to economic recession in 2008-09, the company’s revenue declined by 6.1 percent. As compared to the airlines industry, this decline was quite marginal. As per ‘The Air Transport Association of America’ the total fall in revenue of the aviation companies in 2010 was 18 percent. This loss can be further segregated as 6 percent decline in passenger volume and 13 percent reduction in the average price paid by the customers to fly one kilometre (Rooney, “2009 airline revenue: Worst drop ever”). Effect of recession was also visible on the operating income of Southwest Airlines. In 2007 the operating income was 791 million USD whereas in 2008 it declined to 449 million USD and in 2009 it reached 262 million USD. The fall in operating income also effected the net profitability of the company; in 2008 the net profitability declined by 72.4 percent. The fall in net profitability continued in 2009 and in his year the net income declined further by 44.4 percent. After analysing the financial report of Southwest Airlines for the last three years it appears that though operating revenue declined but the operating expenses continued to grow. For a better understanding of the financial position of the company, financial ratio analysis has been conducted. After the onset of recession, the company has reduced its current liabilities to retain a healthy liquidity position. After considering the current ratio as well as quick ratios for the last three years it can be concluded that Southwest Airlines possesses a sound liquidity. To determine the long term solvency state of Southwest Airlines, leverage position of the company has been determined. After considering the debt-equity ratio it appears that from 2008 onwards this ratio increased marginally but it is not a matter of concern as this ratio is still less than one. The graph reflects that interest coverage ratio has declined sharply over the last three years. Though the amount of interest payable reduced but due to drastic fall in PBIT, the solvency risk has increased to a worrisome state. Effect of recession was too harsh on the profitability of almost all the airlines throughout the world. The same is true for Southwest Airlines. From 2007 till 2009 the profitability of the company declined drastically. The sharpest decline was in the net profit margin. The earning power of the company also declined which also affected the return on equity. Efficiency of a company also depends on the way it manages its debtors and creditors. The accounts receivable turnover ratio of Southwest Airlines declined in 2008 due to liquidity crisis in the global market. The company faced a lot of problems in collecting payment from its debtors. However, as the market conditions are reviving, so things are expected to improve. Even the rate of turnover of the inventory slowed down due to poor demand. As the company is in the service industry, the amount of inventory held by the company is quite low. Thus, low turnover of the inventory is not a major concern. After analysing the financial state of the company, performance of Southwest Airlines was compared with the performance of the industry leaders. In USA regional aviation industry, Southwest Airlines is one of the best performing low cost airlines. The competitors of Southwest are LAN Airlines S.A., GOL Linhas Aéreas Inteligentes S.A., Copa Holdings S.A., JetBlue Airways Corporation and Alaska Air Group, Inc. Among these airline companies, Southwest Airlines has the largest market capitalisation of 8.98 billion USD. The company also has highest Price – Earning ratio at 40.33. As the profitability of Southwest Airlines declined significantly in the last few years, hence it’s Price – Earning to growth ratio is just 0.90 whereas the JetBlue Airways Corporation set the industry benchmark with Price – Earning (P/E) to growth ratio at 2.15. Southwest ranks 10th on the P/E parameter in the industry. The industry’s revenue growth (quarterly y-o-y basis) is 87.10%, as achieved by Republic Airways Holdings, Inc.; Southwest Airlines holds the second rank in terms of revenue growth (quarterly y-o-y) at 21.10%. The EPS growth of Alaska Air Group, Inc. is 100.80% and this is highest in the industry whereas Southwest Airlines managed EPS growth of 22.30% putting it at fifth position in the industry in terms of EPS growth. The same is true for return on equity; the industry benchmark is 51.30% attained by Hawaiian Holdings, Inc., whereas Southwest Airlines ranked 10th with ROE of 4.15%. However, the 5 year growth forecast for Southwest Airlines is 18.67% and this is also considered as the industry benchmark (Yahoo Finance, “Hawaiian Holdings, Inc.”). Stock performance The stock price movement of a company reflects the market image of the company. If the investors feel that the company will perform better in the near future, they start purchasing the stock of that company and soon the share price moves up. On the other hand, if the investors make an assumption that performance of the company will decline in near future, they try to sell the shares and company’s stock price moves down. Therefore, the stock price movement of the company is a good way to analyse investors’ sentiment. Figure 1: Stock price movement of LUV (Source: Morningstar, p.3) After considering the stock price movement of Southwest Airlines from 2007 onwards, it can be seen that when recession hit the worldwide stock markets, even the stock price of Southwest Airlines started moving down. As compared to the industry, fall in the stock price of Southwest Airline was much severe. However, as the market conditions are improving in almost all the developed and developing countries, there has been a correction in the Southwest Airlines stock. The yield to maturity of the company for the last three years is -0.4 whereas the yield to maturity of the industry is -13.1. So, the yield to maturity of the company is quite better as compared to that of the industry. On the other hand, yield to maturity of the S&P 500 for the last three years is 3.6. It can be concluded that Southwest Airlines is performing better as compared to the industry average. The past data indicates that stock price movements of Southwest Airlines and the S&P 500 were almost similar. Therefore it will not be wrong to conclude that with the improvement in the stock market conditions, the stock price of the company will also improve and the investors will be benefited. To analyse stock price movement of Southwest Airlines in the post recession phase, the stock price movement of the company was compared with some of its rival companies. Figure 2: Comparison of stock price movement of LUV with its competitors (Source: Southwest Airline, “Stock Chart”) Lan Airlines S.A. is a passenger as well as cargo service provider airline that offers services in Latin America. Both Southwest Airlines and Lan Airlines S.A. have more or less same market capitalisation and P/E ratio but in the last few months the stock price of Lan Airlines S.A. performed better in the stock market. GOL Linhas Aéreas Inteligentes S.A. is one of the strongest competitors of Southwest Airlines (LUV) in the low cost airline industry. The above graph reflects the stock price movement of GOL as compared to that of the industry and LUV. The graph indicates that share price movements of GOL is comparatively better that that of LUV, but in terms of market capitalisation and P/E ratio, LUV is ahead of GOL. At present the Beta value of Southwest Airlines is 1.22; hence the stock price of the company is quite aggressive in nature. When the market entered the recessionary phase, the company’s stock fell drastically, however, as the market is recovering the stock price of Southwest is expected to perform better than the market index. Future projection of Southwest Airlines After considering the past financial performance of the company, it was found that until the onset of recessionary phase, the company was performing quite satisfactorily. However, as the global markets got severely affected by the economic recession, the number of passengers travelling by the airline declined. To attract customers, airline reduced the prices of different services offered by it. As a result profitability of the company started shrinking. As the western nations are coming out of this phase, demand is also increasing in the aviation industry. Fitch Rating agency has rated Southwest Airlines as a moderate company. It has rated Issuer Default Rating (IDR) as BBB, Senior Unsecured Debt as BBB, Secured Term Loan due 2020 as BBB+ and $600 million Unsecured Revolving Credit Facility expiring 2012 also as BBB (Fitch Ratings, “Fitch Affirms Southwest Airlines at 'BBB'; Outlook to Stable”). The research team of Zacks believes that in 2010 almost all the carriers will recover at a slow rate but they specially favour Southwest Airline because it is expected to recover at a much faster rate. Hence, Zacks has ranked this company at the 3rd position. This decision was mainly influenced by the strong growth of 7.1 percent traffic increase noticed by the company in the month of January 2010 (Zacks Investment Research, “Zacks Industry Outlook Highlights: Southwest Airlines, UAL Corp., US Airways Group, JetBlue Airways Corp. and Alaska Air Group Inc. – Press Releases”). As per the market experts, in 2010 global economy will improve at a steady rate and this will result in high demand for the carrier services. Emergence of developing nations as fast growing economies is also one of the reasons that will improve demand for low cost airlines. The profitability of airline industry is directly related to crude price movement. It is predicted that in the near future oil price will be show moderate increase and thus operating cost of airline companies will remain within control. As a result, the airline companies will post a healthy increase in their profitability (Zacks Equity Research, “U.S. Airline Industry Outlook - June 2010”). Conclusion The information available from the financial analysis of Southwest Airlines indicates that it is one of the high profit generating, low cost airlines. Though in the recession phase, the profit of the company declined sharply, yet it was better than the industry average. The company possesses sound financial position and the financial indicators (financial ratios) are improving at a moderate rate. In the industry, the company is often considered as the leader as it has the largest market capitalisation and highest P/E ratio. This reflects positive sentiment of the investors towards Southwest Airlines. The market researchers gave a moderate rating to the company and they strongly believe that Southwest Airlines will perform better than the industry average. Therefore, RenDi can go ahead with the agreement to supply renewable synthetic diesel fuel to Southwest Airlines for the next five years. Reference Fitch Ratings. Fitch Affirms Southwest Airlines at 'BBB'; Outlook to Stable. July 30, 2010. Trading Markets. August 07, 2010. . IATA. Scheduled Passengers Carried. No date. Publications & Interactive Tools. August 06, 2010. . Morningstar. Southwest Airlines, Co. LUV. July 22, 2010. Morningstar Reports Print Version. August 07, 2010. Reed, T. Southwest Airlines Posts Profit. January 21, 2010. The Street. August 06, 2010. . Rooney, B. 2009 airline revenue: Worst drop ever. January 20, 2010. CNN Money. August 06, 2010. . Southwest Airline. Stock Chart. No date. . Yahoo Finance. Hawaiian Holdings, Inc. August 05, 2010. Yahoo Finance. August 06, 2010. . Zacks Equity Research. U.S. Airline Industry Outlook - June 2010. June 08, 2010. Industry Outlook. August 07, 2010. . Zacks Investment Research. Zacks Industry Outlook Highlights: Southwest Airlines, UAL Corp., US Airways Group, JetBlue Airways Corp. and Alaska Air Group Inc. – Press Releases. February 12, 2010. Straight Stocks. August 07, 2010. . Read More