Stick With Quality: Delta Air Lines Is A Strong Buy With 46% Upside – Delta Air Lines, Inc. (NYSE:DAL) No ratings yet.

Delta Air Lines (DAL) is a leader in the airline industry. The company has shored up its balance sheet, improved its fleet, and committed to high levels of shareholder cash returns. Yet, it trades at less than 10 times trailing earnings. Shares are a strong buy.

Highest-Quality Operator In A Competitive Space

The airline industry is notorious for being very competitive and lacking pricing power. In recent years, this has improved mildly as a couple top operators have taken great market share:

(US domestic market share by sales 2018, Statista)

DAL has made great efforts to improve its business model, including improving margins and its balance sheet:

(Source: 2018 Investor Day)

DAL is often called the best of breed in the airline industry. This has a lot to do with the company’s history of strong execution and performance:

(Source: 2019 March Presentation)

While pricing power remains difficult in the industry, DAL has pushed for growth through increasing seat capacity and reducing costs through airline fleet upgrades.

One of DAL’s strategies is that of becoming entrenched in a high-traffic hub and then “upgauging” its aircraft to reduce fuel costs:

(Source: 2018 Investor Day)

In addition to reducing in fuel costs per seat, these new aircraft also allow for more premium seating:

(Source: 2018 Investor Day)

On an ironic note, airline travelers may consider some of these “premium” seating to be more of a downgrade, as it seems that travelers need to pay more and more for the same services, but kidding aside, this is nonetheless a positive for the business and shareholders. Perhaps DAL shareholders make for happier travelers?

The company has entered joint ventures with many international airlines, which allows it to tap the larger global international flight market:

(Source: 2018 Investor Day)

Finally, DAL has worked hard to diversify its revenue stream away from over-reliance on just main cabin sales – as we can see below, the company has seen its revenues from premium seating and products increase dramatically, as well as some growth in contribution from its American Express (AXP) credit card partnership:

(Source: 2018 Finance Presentation)

The airline industry isn’t the most stable among the stocks I usually cover, but I think DAL’s strategy of focusing on profitability through reducing costs, diversifying revenue streams, and gaining differentiation through providing better customer experience helps to reduce its risk and increase the quality of its earnings.

High Correlation To The Price Of Oil

One of the issues facing airline stocks is their high reliance on the price of oil. In fact, DAL sees the biggest impact to operating costs from aircraft fuel costs, as these make up one of its largest expenses and fluctuates the most:

(Source: 2018 10-K)

In the above chart, we can see that the increase in operating expense was almost solely due to increases in fuel costs.

We can see below that fuel costs last year increased basically in direct correlation to the price per gallon (the roughly 29.3% increase in fuel closely tracks the 27% increase in price per gallon):

(Source: 2018 10-K)

DAL has tried to moderate the oil price volatility by operating its own refineries, which supply 80% of its domestic flights. Even so, it’s clear that the airline’s earnings are still highly correlated to fluctuations in the price of oil, and as a result, it is arguable that its investments in improving its fleet is a perpetual necessity in order to improve fuel efficiency.

Solid Balance Sheet

DAL has a solid, but not necessarily super strong, balance sheet. The company had debt-to-EBITDAR of 1.9 in 2018.

Its investment grade rating of BBB- and equivalent from all agencies ranks second best in the sector, behind only Southwest Airlines (LUV):

(Source: 2019 Southwest Airlines April Presentation)

DAL is targeting a range of 1.5-2.5 times, and believes this allows it to maintain its investment grade rating even through low cycles. While I would prefer for lower leverage (perhaps in the 1.0-2.0 range) and an associated higher credit rating, I feel that the company’s higher levels of profitability than before help to reduce its financial risk in a downturn. I expect DAL to continue to take market share as its increased scale help to fend off lower-priced competitors – this would improve its quality of cash flows and increase its capacity for leverage.

Shareholder Yield Machine

DAL targets 50% of cash flow towards reinvestment in its fleet. This modernizes the company’s fleet, which helps to improve fuel efficiency as well as the customer experience.

(Source: 2019 March Presentation)

It is difficult to determine the ROI on this reinvestment because of the stiff competition in the sector. That said, this is one important way that DAL reduces its operational risk, while working to maintain its leadership in the sector – I view it as an intangible value-add to shareholders that, while not necessarily directly producing results in the bottom line, is an effective way to improve the business.

As a shareholder, one is probably, and rightfully so, most concerned with actual cash returned to shareholders through dividends and share repurchases, known as “shareholder yield.” As we can see below, DAL has consistently returned large amounts of cash to shareholders and is targeting $2.5 billion in 2019:

(Source: 2019 March Presentation)

This is a company that is carefully balancing both reinvesting in the business and rewarding shareholders – I think future credit upgrades and multiple revaluation upwards are in store in the long term.

Valuation And Price Target

DAL trades at around 9.3 times trailing earnings of $5.83. It has guided for EPS between $6 and $7 in 2019. DAL also pays a $1.40 annual dividend for a yield of 2.59%. My 12-month price target is $77, or about 12 times the midpoint of 2019 EPS guidance. This represents just over 46% total return upside. I view this multiple to be justified in light of my projected ~3% long-term earnings growth, stemming from a combination of increased seat capacity, declining fuel costs and declining interest expenses (if and when credit ratings improve).

Risks

  • As stated above, DAL is highly correlated to the price of oil. The airline’s ever-improving fleet will help to smooth out a bit of the volatility, but a sudden spike in oil prices may lead to a swift depression in operating earnings. I view this to be unlikely because of the large oil production stemming from the Permian basin, but it is a risk that has happened in the past and is arguably the most important risk that investors must watch out for.

  • DAL may be particularly exposed in an economic slowdown as consumers curb discretionary airline travel. To combat this, it must continue working hard to take market share from competitors – my worst-case scenario would be if the company is unable to differentiate its product, and thus, consumers flock to lower-priced competitors. I view this scenario as unlikely due to the company’s high levels of reinvestment.

  • Due to its leverage, DAL is also exposed to the threat of rising interest rates. I hope the company chooses to gradually reduce its leverage moving forward, securing a higher credit rating and reducing its interest costs. Nonetheless, its leverage is not too concerning and its maturities are well-staggered, more or less alleviating any fears of a liquidity crunch.

Conclusion

This isn’t a slam dunk. But I think that DAL has the right management and operational strategy to allow it to thrive in good times and survive the bad. I rate shares a “Strong Buy” on valuation.

(TipRanks: Buy DAL)

Disclosure: I am/we are long DAL, LUV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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