Lukas Wunderlich
Investment Thesis
Delta Air Lines (NYSE:DAL) delivered yet another impressive quarter with an equally impressive guidance for Q4. The company is enjoying the shift in consumer preferences as well as the surge in corporate and international travel. Furthermore, the strength of its diverse revenue streams is adding more fuel to its growth. From a valuation perspective, the airline appears to be extremely undervalued.
A Snapshot of Delta Air Lines’ Q3 Performance
There was so much to like about DAL’s Q3 performance. The airline generated its highest quarterly revenue ever, coming in at $12.8 billion, 3% above the revenues generated during the third quarter of 2019. Operating income came in at $1.5 billion, which translates to an operating margin of 11.6%. This is the second consecutive quarter where the company has generated double-digit operating margins, and the airline was able to achieve this despite operating with a network that was about 17% smaller compared to the same period in 2019. The only negative was the EPS figure, which not only missed analyst estimates by $0.02, but was also down 35% compared to Q3 of 2019.
However, the guidance more than made up for this. DAL now sees total revenue growth somewhere between 5 and 9% in the fourth quarter. Operating margins are expected to come in between 9 and 11% and EPS is expected to be somewhere between $1.00 and $1.25. The airline also expects fuel prices to be in the range between $3.35 and $3.55, which would represent a marginal decline sequentially.
Consumers Brush Aside the Rise in Air Fares
One of the key takeaways from the Q3 earnings call was how the price increases carried out by the airline, to offset the inflationary pressures, have barely created a dent in the overall demand. In the U.S., airline fares rose 0.8% in September, a major contributing factor to the red-hot inflation. According to Forbes, on an annualized basis, inflation driven by air fares was up 43%, the highest on record and more than five times higher than the overall inflation rate of 8.2%. Despite this, Delta managed to generate record revenues.
Moreover, these elevated prices are expected to be sticky even in the fourth quarter. To put things in perspective, according to Hopper travel booking app, the average round-trip airfare, this year, for trips between November 20 and November 24, which marks the Thanksgiving period, costs about $350. This represents a 43% increase YoY and is 22% higher than during the pre-pandemic period.
In the case of DAL, the cheapest ticket for a round-trip from New York to Los Angeles, during the Thanksgiving period, according to Skyscanner, costs $500. This price is for seats in Delta’s Basic Economy, which appear to be a thing of the past if we are to believe the airline’s management. One of the drivers behind the company’s strong Q3 performance and the healthy Q4 guidance was the increased rate of adoption of premium products, which together with the airline’s other revenue streams, accounted for 54% of the company’s total revenue. It appears that the airline’s premium products, which were driving its recovery post-COVID, are now helping to accelerate its growth.
Furthermore, the surge in corporate travel and the airline’s expansion of the premium products into more international flights, are adding more fuel to the fire. For example, the cheapest premium economy ticket on the aforementioned New York-Los Angeles flight, for traveling during the Thanksgiving period, costs $919, a jump of 84%. On the airline’s website, there is only one ticket left at that price!
AmEx Partnership is Paying Off Faster than Expectations
The other highlight of DAL’s Q3 results is the strong performance of the company’s partnership with American Express, which resulted in total revenues of $1.4 billion, 37% higher than 2019. The airline now expects total remuneration from its partnership with AmEx to be around $5.5 billion, which makes the management’s 2024 target of $7 billion, extremely conservative.
The growth can be attributed to the surge seen in Delta’s SkyMiles frequent-flyer programme. SkyMiles members now account for over 60% of the company’s passenger revenues. The company also announced that it was partnering with Starbucks, which further expands its loyalty ecosystem.
The strong performance of its loyalty programme is further proof that the airline’s growth is sustainable even after air fares normalize.
Delta’s Capital Allocation Program Should be Commended
Finally, the airline’s capital allocation programme is further proof of how well-managed the company is. Instead of initiating buybacks and/or dividends, which are stock price-boosting moves, especially in the current climate, the management is maintaining its focus to utilize its excess cash to drive down the company’s debt. DAL’s debt repayment stands at $4 billion YTD, keeping the airline on pace to return to investment-grade rating by 2024.
At a time when investors are more focused on income-yielding stocks, the fact that the management remains steadfast in their debt-reduction purposes is commendable and only adds more credibility to their ways of running the airline. Furthermore, using their free cash flows to refresh the company’s existing fleet is also paying off. The purchase of the A321neos, for instance, has been a smart move as these flights are generating margins that are approximately 10% higher than the ones that are getting replaced.
DAL Stock Valuation
|
Forward P/E Multiple Approach |
|
|
Price Target |
$45.50 |
|
Projected Forward P/E multiple |
8.06x |
|
Projected Forward PEG Ratio |
0.09 |
|
Projected Earnings growth |
90% |
|
Projected FY23 EPS |
$1.90 |
Source: Refinitiv, Author’s Projections, and Company’s Q3 Press Release
The airline expects Q4 earnings to come in between $1.00 and $1.25. Given the tailwinds and given that fuel costs could come in sequentially lower, I assumed that Q4 EPS would come in at $1.25. This would bring the airline’s FY22 non-GAAP EPS to $2.97.
The company currently trades at a forward P/E of 7.09x and a forward PEG ratio of 0.09, according to Refinitiv. The industry median forward P/E stands at 8.06x, which, in my opinion, is the bare minimum that DAL should be trading at, given how it has performed. Assuming a forward P/E multiple of 8.06x and a forward PEG ratio of 0.09, this would give a future earnings growth of 90%, which translates to FY23 projected EPS of $5.64.
At a forward P/E of 8.06x and FY23 EPS of $5.64, I get a price target of $45.50, which represents an upside of 40% to the closing price on Wednesday, October 19th 2022.
Risk Factors
With an impending economic slowdown looming, there is the possibility of a rapid destruction of consumer demand despite the consumers’ willingness to travel. The airline industry is extremely susceptible to any form of sharp slowdown, an aspect that has not changed no matter how high the demand is at present.
Then there’s the risk of rising fuel prices, a threat that is expected to remain until we get some clarity on the Russia-Ukraine conflict. While the airline is expecting fuel prices to marginally decline in Q4, it’s a very fragile scenario at present. With OPEC+ opting for production cuts, the risk of higher oil prices cannot be ruled out even if the increase will be softened by falling demand in the event of a recession.
Finally, while the pace of debt reduction has been impressive, it’s important that the airline continues to sustain it. In the event that we do fall into a recession, sustaining the debt reduction programme might not be possible, which is a problem given that its debt-to-equity ratio, according to Refinitiv, stands at 693%!
Concluding Thoughts
Overall, there is no doubt that DAL is a well-managed airline. And now, it has significant tailwinds to support its growth as well. As consumer preferences shift more towards experiences, the airline industry in general and DAL in particular, are only going to benefit. The surge in corporate travel and international travel, both major revenue sources for DAL, are also driving the airline’s recovery from the pandemic. Then there’s the strength of the airline’s other revenue streams, especially its partnership with American Express, which is displaying tremendous growth.
Finally, the company’s capital allocation is commendable as it uses this period of recovery to drive down its debt levels. With approximately 40% upside potential in its stock price as a result of all these catalysts, it’s clear skies ahead for DAL’s investors.
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