Seeking Alpha
Value, long only, debt, research analyst
Profile| Send Message| ()  

Looking at profitability is a very important step in understanding a company. Profitability is essentially why the company exists and a key component of deciding 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 Southern Company's (SO) earnings and earnings growth, profit margins, profitability ratios and cash flow.

Through the above-mentioned four main metrics, we will understand more about the company's profitability. And by comparing this summary to other companies in the same sector, you will be able see which has been the most profitable.

Earnings and Earnings Growth

1. Earnings = Sales x Profit Margin

  • 2010 - $17.456 billion x 11.69% = $2.040 billion
  • 2011 - $17.657 billion x 12.84% = $2.268 billion

Southern Company's earnings increased from $2.040 billion in 2010 to $2.268 billion in 2011 or an increase of 11.17%.

2. Five-year historical look at earnings growth

  • 2007 - $1.734 billion, 10.2% increase over 2006
  • 2008 - $1.742 billion, 0.46% increase
  • 2009 - $1.708 billion, 1.99% decrease
  • 2010 - $2.040 billion, 19.44% increase
  • 2011 - $2.268 billion, 11.18% increase

In analyzing Southern Company's earnings growth over the past five years, you can see that overall the company's earnings have been trending up with a slight decrease in 2009. Overall, the 2011 earnings are 30.80% higher than 2007.

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 Southern Company's gross profits for the past two years:

  • 2010 - $17.456 billion - $7.262 billion = $10.194 billion
  • 2011 - $17.657 billion - $6.870 billion = $10.787 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.).

In analyzing Southern Company's gross margin over the past five years, the margin looks to be quite consistent. There was a low in 2008 of 55.43% and a high in 2011 with a margin of 61.09%. The 2011 gross profit margin is above the 5-year average of 58.52%.

  • 2007 - $8.982 billion / $15.353 billion = 58.50%
  • 2008 - $9.494 billion / $17.127 billion = 55.43%
  • 2009 - $9.317 billion / $15.743 billion = 59.18%
  • 2010 - $10.194 billion / $17.456 billion = 58.40%
  • 2011 - $10.787 billion / $17.657 billion = 61.09%

The increase in the gross margin implies that management was more efficient in its manufacturing and distribution during the production process in 2011 compared to the 5-year average.

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 - $4.231 billion
  • 2011 - $3.802 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.

Like the profit margin, Southern Company's operating margin has been very consistent over the past five years. The 2011 operating margin of 23.96% is above the 5-year average of 21.73%.

  • 2007 - $3.326 billion / $15.353 billion = 21.66%
  • 2008 - $3.506 billion / $17.127 billion = 20.47%
  • 2009 - $3.268 billion / $15.743 billion = 20.76%
  • 2010 - $3.802 billion / $17.456 billion = 21.78%
  • 2011 - $4.231 billion / $17.657 billion = 23.96%

As the 2011 operating margin is above the 5-year average, this implies that there has been an increase in the percentage of total sales left over after paying for variable costs of production such as wages and raw materials.

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.

Southern Company's net profit margin has been very consistent over the past five years. Like the previous years, 2011 has proven to be the strongest as far as these profit ratios are concerned.

  • 2007 - $1.734 billion / $15.353 billion = 11.29%
  • 2008 - $1.742 billion / $17.127 billion = 10.17%
  • 2009 - $1.708 billion / $15.743 billion = 10.85%
  • 2010 - $2.040 billion / $17.456 billion = 11.68%
  • 2011 - $2.268 billion / $17.657 billion = 12.84%

As the 2011 net profit margin has been stronger than the past five years, this implies that there has been an increase in the percentage of earnings that the company is able to keep.

Profitability Ratios

9. 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."

Southern Company's ROA has been very steady over the past five years. The company has had a low ROA of 3.60% and a 5-year high of 3.83%

  • 2007 - $1.734 billion / $45.789 billion = 3.78%
  • 2008 - $1.742 billion / $48.347 billion = 3.60%
  • 2009 - $1.708 billion / $52.046 billion = 3.81%
  • 2010 - $2.040 billion / $55.032 billion = 3.71%
  • 2011 - $2.268 billion / $59.267 billion = 3.83%

The current ROA of 3.83% is above the 5-year average of 3.74%. This implies that management has been slightly more efficient at using the company's assets to generate earnings compared to its 5-year average.

10. 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 - $1.734 billion / $12.385 billion = 14.00%
  • 2008 - $1.742 billion / $13.276 billion = 13.11%
  • 2009 - $1.708 billion / $15.585 billion = 10.96%
  • 2010 - $2.040 billion / $16.909 billion = 12.06%
  • 2011 - $2.268 billion / $18.285 billion = 12.04%

Southern Company's ROE over the past five years is not as strong as the other profitability ratios listed. The current ROE of 12.04% is slightly below the 5-year average of 12.43%. This reveals that the company is generating less profits compared to shareholders' equity based on the 5-year average.

Cash Flows

11. 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.

Over the past five years, Southern Company's free cash flow has been negative from 2007 to 2010. In 2011, the company reported a positive cash flow:

  • 2007 - $3.434 billion - $3.545 billion = $(150) million
  • 2008 - $3.464 billion - $3.961 billion = $(563) million
  • 2009 - $3.263 billion - $4.670 billion = $(1.407) billion
  • 2010 - $3.991 billion - $4.086 billion = $(95) million
  • 2011 - $5.903 billion - $4.525 billion = $1.378 billion

The latest number, which is on the plus side, indicates that Southern Company has enough cash to develop new products, make acquisitions, pay dividends and reduce debt.

12. 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.

Southern Company's cash flow margin is positive, so it does not have to take these measures to continue operating.

  • 2007 - $3.434 billion / $15.353 billion = 22.36%
  • 2008 - $3.464 billion / $17.127 billion = 20.22%
  • 2009 - $3.263 billion / $15.743 billion = 20.73%
  • 2010 - $3.991 billion / $17.456 billion = 22.86%
  • 2011 - $5.903 billion / $17.657 billion = 33.43%

Summary

In analyzing Southern Company's earnings growth over the past five years, you can see that overall the company's earnings have been trending up with a slight decrease in 2009, and the 2011 earnings are 30.80% higher than 2007.

As illustrated above, the listed profit margins show very consistent results with a strong 2011, when the company reported positive results compared to the 5-year average.

Like the profitability margins, the ROA and ROE show consistent results. The ROA continued to show very consistent results compared with its 5-year average, while the ROE was the weakest metric shown, with below the 5-year average results.

In four of the past five years, Southern Company has shown negative cash flow. In 2011, the company reported positive cash at $1.378 billion. The company's cash flow margin showed strong results at 33.43%; this implies that the company has the ability to develop new products, make acquisitions, pay dividends and reduce debt without having to borrow or raise money to maintain operations.

The analysis of Southern Company's profitability reveals a solid company that had a strong 2011 with very consistent results over the past five years.

Disclosure:

I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Southern Company: Profitability Analysis