Does Southwest Airlines’s (NYSE:LUV) Statutory Profit Adequately Reflect Its Underlying Profit?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it’s not always clear whether statutory profits are a good guide, going forward. Today we’ll focus on whether this year’s statutory profits are a good guide to understanding Southwest Airlines (NYSE:LUV).

It’s good to see that over the last twelve months Southwest Airlines made a profit of US$163.0m on revenue of US$16.6b. Below, you can see that both its revenue and its profit have fallen over the last three years.

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NYSE:LUV Earnings and Revenue History August 24th 2020

Of course, when it comes to statutory profit, the devil is often in the detail, and we can get a better sense for a company by diving deeper into the financial statements. Therefore, today we’ll take a look at Southwest Airlines’ 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.

Zooming In On Southwest Airlines’ Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company’s free cash flow (FCF) matches its profit. 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. The ratio shows us how much a company’s profit exceeds its FCF.

Therefore, it’s actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2020, Southwest Airlines had an accrual ratio of -0.18. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of US$1.5b during the period, dwarfing its reported profit of US$163.0m. Southwest Airlines’ free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. However, that’s not the end of the story. 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. Southwest Airlines expanded the number of shares on issue by 9.7% over the last year. Therefore, each share now receives a smaller portion of profit. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out Southwest Airlines’ historical EPS growth by clicking on this link.

How Is Dilution Impacting Southwest Airlines’ Earnings Per Share? (EPS)

Unfortunately, Southwest Airlines’ profit is down 92% per year over three years. Even looking at the last year, profit was still down 93%. Sadly, earnings per share fell further, down a full 93% in that time. 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 Southwest Airlines’ 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 the ordinary retail shareholder, EPS is a great measure to check your hypothetical “share” of the company’s profit.

The Impact Of Unusual Items On Profit

While the accrual ratio might bode well, we also note that Southwest Airlines’ profit was boosted by unusual items worth US$999m in the last twelve months. While it’s always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it’s very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. Southwest Airlines had a rather significant contribution from unusual items relative to its profit to June 2020. 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 Southwest Airlines’ Profit Performance

In conclusion, Southwest Airlines’ accrual ratio suggests its earnings are well backed by cash but its boost from unusual items is probably not going to be repeated consistently. Meanwhile, the dilution was a negative for shareholders. After taking into account all the aforementioned observations we think that Southwest Airlines’ profits probably give a generous impression of its sustainable level of profitability. If you’d like to know more about Southwest Airlines as a business, it’s important to be aware of any risks it’s facing. For example, we’ve discovered 5 warning signs that you should run your eye over to get a better picture of Southwest Airlines.

In this article we’ve looked at a number of factors that can impair the utility of profit numbers, and we’ve come away cautious. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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