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Looking at profitability is a very important step in understanding a company. Profitability is essentially why the company exists and a key component in deciding whether to invest or to remain invested in a company. There are many metrics involved in calculating profitability, but for this article, I will look at Spectra Energy's (SE) earnings and earnings growth, profit margins, profitability ratios and cash flow.

Through the above-mentioned four main metrics we will get an idea about the company's profitability over the past 5 years. We will also get an idea how hard Spectra Energy was hit by the crisis and how well the company is recovering.

By comparing this summary to other companies such as Enbridge Inc (ENB) and Williams Companies Inc. (WMB), which are in the same sector, you will be able see which has been the most profitable.

All material is sourced from Morningstar and the Spectra Energy's webpage.

About the Business

Spectra Energy Corp, through its subsidiaries and equity affiliates, owns and operates a large and diversified portfolio of complementary natural gas related energy assets and is one of North America's leading natural gas infrastructure companies. For close to a hundred years, the company and its predecessor companies have developed critically important pipelines and related energy infrastructure connecting natural gas supply sources to premium markets.

Spectra Energy operates in three key areas of the natural gas industry: gathering and processing, transmission and storage, and distribution. The company provides transportation and storage of natural gas to customers in various regions of the northeastern and southeastern United States, the Maritime Provinces in Canada, the Pacific Northwest in the United States and Canada, and in Ontario Canada. The company also provides natural gas sales and distribution services to retail customers in Ontario, and natural gas gathering and processing services to customers in western Canada. In addition, the company also owns a 50% interest in DCP Midstream, LLC (DCP Midstream), one of the largest natural gas gatherers and processors in the United States, which is based in Denver, Colorado.

Below is a map of the physical infrastructure of Spectra Energy's assets.

Above information and Map from Company Website

Spectra Energy's profitability and growth come from many segments of company. With continued successful partnerships with company's like DCP Midstream (DPM), and the high-performing partnership with Phillips 66 (PSX), the company's profitability will continue to grow. An example of this partnership is that DCP Midstream is funding its own growth, and last year paid Spectra Energy almost $400 million in distributions.

The below numbers encompass all aspects of the company's earnings and growth.

Earnings and Earnings Growth

1. Earnings = Sales x Profit Margin

  • 2010 - $4.945 billion x 21.21% = $1.049 billion
  • 2011 - $5.351 billion x 22.13% = $1.184 billion

Spectra Energy's earnings increased from $1.049 billion in 2010 to $1.184 billion in 2011, an increase of 12.87%.

2. Five-year historical look at earnings growth

  • 2007 - $957 billion, 21.81% decrease over 2006
  • 2008 - $1.129 billion, 17.97% increase
  • 2009 - $848 million, 24.89% decrease
  • 2010 - $1.049 billion, 23.70% increase
  • 2011 - $1.184 billion, 12.87% increase

In looking at Spectra Energy's earnings over the past five years, you can see the dip in earnings in 2009 but a steady increase in earnings up to 2011.

In 2009, as the economy fell so did the earnings of the company. Spectra Energy's earnings fell to a recent low when it reported earnings of $848 million.

As the economy has been recovering, the earnings have been increasing. The earnings have been increasing as the need for natural gas and natural gas product have been increasing. In 2011, as the economy and need for natural gas has been strengthening the company reported record earnings of $1.184 billion.

As reported by Morningstar, the 2012 TTM Spectra Energy sales have been reported at $5.156 billion and the net income is reported at $1.016 billion.

Profit Margins

3. Gross Profit = Total Sales - Cost of Sales

In analyzing a company, gross profit is very important because it indicates how efficiently management uses labor and supplies in the production process. More specifically, it can be used to calculate gross profit margin. Here are Spectra Energy's gross profits for the past two years:

  • 2010 - $4.945 billion - $1.056 billion = $3.889 billion
  • 2011 - $5.351 billion - $1.142 billion= $4.209 billion

4. Gross Profit Margin = Gross Income / Sales

The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

Specific to Spectra Energy, the gross margin is calculated by the total sales minus the natural gas and petroleum products purchased. In reviewing Spectra Energy's gross margin over the past five years, we can see that the company's gross margin has been steadily increasing. The 5-year low for the gross margin was reported in 2008 with a margin of 68.74%. The 5-year high for the margin was in 2011 with a margin of 78.66%. The 2011 gross profit margin of 78.66% is above the 5-year average of 74.41%.

  • 2007 - $3.326 billion / $4.742 billion = 70.14%
  • 2008 - $3.488 billion / $5.074 billion = 68.74%
  • 2009 - $3.454 billion / $4.552 billion = 75.88%
  • 2010 - $3.889 billion / $4.945 billion = 78.65%
  • 2011 - $4.209 billion / $5.351 billion = 78.66%

As the gross margin is above the 5-year average this implies that management has been more efficient in the company's manufacturing and distribution during the production process over the past 5 years.

5. Operating income = Total Sales - Operating Expenses

The amount of profit realized from the operations of a business after taking out operating expenses - such as cost of goods sold (COGS) or wages - and depreciation. Operating income takes the gross income (revenue minus COGS) and subtracts other operating expenses, then removes depreciation. These operating expenses are costs that are incurred from operating activities and include things such as office supplies and heat and power.

  • 2010 - $1.664 billion
  • 2011 - $1.755 billion

6. Operating Margin = Operating Income / Total Sales

Operating margin is a measure of the proportion of a company's revenue that is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs such as interest on debt. If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.

The operating margin of Spectra Energy is calculated as total operating revenues minus natural gas and petroleum products purchased, Operating, maintenance, other Depreciation and amortization and gains of other sales of assets and other net.

Over the past 5 years, the operating margin has been increasing. In 2007, the company reported an operating margin of 30.13%. In 2011 the company had a operating margin of 32.79%.

  • 2007 - $1.429 billion / $4.742 billion = 30.13%
  • 2008 - $1.438 billion / $5.074 billion = 28.34%
  • 2009 - $1.464 billion / $4.552 billion = 32.16%
  • 2010 - $1.664 billion / $4.945 billion = 33.65%
  • 2011 - $1.755 billion / $5.351 billion = 32.79%

The 2011 operating margin of 32.79% is above the 5-year average of 31.41%. This implies that there has been more of a percentage of the total sales left over after paying for variable costs of production such as wages and raw materials compared to the 5-year average.

7. Net Profit Margin = Net Income / Total Sales

A ratio of profitability calculated as net income divided by revenue, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings.

Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Over the past 5 years, Spectra Energy's net profit margin revealed a dip in 2009 but a recovery to 2011. In 2011 the net profit margin of 22.13% is above the 5-year average of 20.88%.

  • 2007 - $957 million / $4.742 billion = 20.18%
  • 2008 - $1.129 billion / $5.074 billion = 22.25%
  • 2009 - $848 billion / $4.552 billion = 18.63%
  • 2010 - $1.049 billion / $4.945 billion = 21.21%
  • 2011 - $1.184 billion / $5.351 billion = 22.13%

As the 2011 net profit margin of 22.13% is above the 5-year average of 20.88%, this implies that there has been an increase in the percentage of earnings that the company is able to keep compared to the company's 5-year average.

The listed profitability margins are revealing that the company is gaining strength. Even though the company's margins are very consistent and not volatile, they are still showing slow signs of strength as all of the listed profitability margins are above their reported 5 year averages.

Profitability Ratios

8. ROA - Return on Assets = Net Income / Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."

The 2011, ROA of Spectra Energy reveals a return to the 2007 and 2008 levels. The 2011 ROA of 4.21% is slightly above the 5-year average of 4.19%.

  • 2007 - $957 million / $22.970 billion = 4.17%
  • 2008 - $1.129 billion / $21.924 billion = 5.15%
  • 2009 - $848 billion / $24.079 billion = 3.52%
  • 2010 - $1.049 billion / $26.686 billion = 3.93%
  • 2011 - $1.184 billion / $28.138 billion = 4.21%

As the 2011 ROA of 4.21% is above the 5-year average of 4.19%, this implies that management has had the ability to use the company's assets to generate earnings compared to its 5-year average.

9. ROE - Return on Equity = Net Income / Shareholders' Equity

As shareholders' equity is measured as a firm's total assets minus its total liabilities, ROE reveals the amount of net income returned as a percentage of shareholders' equity. The return on equity measures a company's profitability by revealing how much profit it generates with the amount shareholders have invested.

  • 2007 - $957 million / $6.857 billion = 13.96%
  • 2008 - $1.129 billion / $5.540 billion = 20.38%
  • 2009 - $848 billion / $7.125 billion = 11.90%
  • 2010 - $1.049 billion / $7.809 billion = 13.43%
  • 2011 - $1.184 billion / $8.065 billion = 14.68%

With the exception of 2008 when the ROE spiked at 20.38% the return on equity has been increasing. As the ROE has increased over the past three years, this reveals that there has been an increase in how much profit has been generated compared to the amount that shareholders have invested.

Cash Flows

10. Free Cash Flow = Operating Cash Flow - Capital Expenditure

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow ((FCF)) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.

All of the past five years, Spectra Energy's free cash flow has been positive.

  • 2007 - $1,467 billion - $1,202 billion = $265 billion
  • 2008 - $1,805 billion - $1,502 billion = $303 billion
  • 2009 - $1,760 billion - $980 billion = $780 billion
  • 2010 - $1,408 billion - $1,346 billion = $62 billion
  • 2011 - $2,186 billion - $1,915 billion = $271 million

11. Cash Flow Margin = Cash Flow from Operating Activities / Total Sales

The higher the percentage, the more cash available from sales.

If a company is generating a negative cash flow, it shows up as a negative number in the numerator in the cash flow margin equation. This means that even as the company is generating sales revenue, it is losing money. The company will have to borrow money or raise money through investors in order to keep on operating.

As Spectra Energy's cash flow margin is positive, it does not have to take the above measures to continue operating.

  • 2007 - $1.467 billion / $4.742 billion = 30.94%
  • 2008 - $1.805 billion / $5.074 billion = 35.57%
  • 2009 - $1.760 billion / $4.552 billion = 38.66%
  • 2010 - $1.408 billion / $4.945 billion = 28.47%
  • 2011 - $2.186 billion / $5.351 billion = 40.85%

Summary

In looking at Spectra Energy's earnings over the past five years, you can see the dip in earnings in 2009 but a steady increase in earnings up to 2011.

In 2009, As the economy fell so did the earnings of the company. Spectra Energy's earnings fell to a recent low when it reported earnings of $848 million. As the economy has been recovering, the earnings have been increasing. The earnings have been increasing as the need for natural gas has been improving. In 2011, as the economy and need for natural gas has been strengthening the company reported record earnings of $1.184 billion.

The listed profitability margins are revealing that the company is gaining strength. Even though the company's margins are very consistent and haven't been volatile, they are still showing slow signs of strength as all of the listed profitability margins are above their reported 5 year averages.

Spectra Energy has had positive cash flow over the past 5 years ensuring that the company will not have to borrow money or raise money through investors in order to keep on operating.

Over the next few years, analysis at Bloomberg Businessweek are predicting a drop in earnings in FY 2012 and cautious growth in 2013. Analysts are estimating EPS for FY 2012 at $1.49 and a EPS for 2013 at $1.70.

To read more on Spectra Energy please read:Spectra Energy: Inside The Numbers.

An excellent article on Spectra Energy is: Spectra Energy: Above-Average Gas Utility Yield And MLP Flavor Without The Tax Hassles.

Source: Spectra Energy: Profitability Analysis