We have little new information to add to the great literature one can find in Seeking Alpha articles (and their comments section) regarding Delta Air Lines (DAL), a business I have followed for a number of years, but only bought for the first time this week at around $45.50.
Furthermore, I write this article in great haste due to the large volatility in market prices in the US airline industry today. Whilst I will briefly summarise the main points regarding this industry, my real value added may be viewed as simply focusing the reader to be aware of the recent price action of Delta Air Lines, and to consider whether it seems fair that it should be trading at 0.62x 2019 sales, 6.2x 2019 earnings, and at a 10% free cash flow (FCF) yield on normalised cash flow.
Many fear the Coronavirus will create a demand shock that can dramatically hit the capital intensive, high fixed cost airline industry. However, Delta will likely be the last player standing with the strongest balance sheet, and the most profitable metrics. It is also partially shielded by a consolidated US industry, and being based in what may be one of the few self sufficient countries in the world due to having access to water, grain, meat, fish, energy, an educated workforce, the rule of law, and a large population. Should the apocalypse come true and the world temporarily stop international travel and interaction, I suspect the US would be the global winner.
There is an old adage that says buy cyclicals when they look expensive, and sell them when they look cheap. Airlines have historically been cyclical due to their exposure to a number of external cyclical factors. This includes macro factors such as local/global demand (GDP dependent), interest rates, wages, and oil prices, as well as industry factors such as supply (airline capacity), and high fixed costs.
So why buy Delta Air Lines when it looks optically cheap at a 6x P/E ratio?
Well, consolidation over many decades has reached a point that has resulted in American (AAL), United (UAL), Delta and Southwest (LUV) capturing roughly 75% of the U.S. domestic market. This has the potential of creating more rational market behaviour, hence a better balance between demand and supply. This in turn can allow more rational pricing, hence in theory, the potential of steadier profits. On a more granular level, we are also seeing more concentration in the airline hubs, which provides better unit economics through the potential of extracting a revenue premium per available seat mile, but also lower unit costs compared with other smaller network carriers at that hub.
However, we must not forget we are dealing with a commodity industry where gross margins are volatile, and the major players still struggle to generate levels over the mid-20s. Considering there is limited buyer concentration, the likely answer for this low gross margin is a balance between healthy competition and supplier concentration. Regarding the latter, consider the aircraft manufacturers (Boeing (BA), Airbus (OTCPK:EADSF) (OTCPK:EADSY)), and aircraft leasers (AerCap (AER)), as well as a number of other advanced suppliers (i.e. engine suppliers such as Rolls Royce (OTCPK:RYCEF)). However, leading players such as Southwest and Delta are now starting to generate operating margins in the mid-teens, and respectable returns on assets approaching 10%. The market awaits to see if they can continue to achieve such profitability during a downturn, and whether consolidation will really prove to consistently increase the profit pool for the industry, or if it’s just another case of peak cyclical earnings. Current market pricing clearly indicates the latter.
At an accidental level, besides the continuous lifespan of the current economic cycle, the grounding of the Boeing 737 MAX likely has the net effect of restraining supply, hence acting as a net positive to the profit pool of the industry through higher pricing. This is of course a temporary external effect. Indeed, another reason why Delta was chosen as the investment vehicle of choice for exposure to the US Airline industry was because it has no exposure to the Boeing 737 MAX, hence the company can enjoy the fruits of any supply issues on pricing, without having to suffer to the same extent the cost implications.
The Situation at Delta Air Lines
Again, due to the abundance of material already available on Seeking Alpha on Delta Air Lines, I will keep a summary of the business brief.
Delta Air Lines operates 912 commercial aircraft, making it the second largest airline fleet in the world. Delta’s fleet consists of about 58% Boeing, 34% Airbus, and about 8% are McDonnell Douglas. Its 757 narrow body aircraft comprise about 83% of its fleet, while its 155 wide body aircraft comprise the remaining 17%. Delta is known for purchasing or leasing older generation aircraft, and it flies aircraft for much longer than most other major airlines. Delta has one of the oldest fleets of any United States airline, with an average fleet age of 14.9 years. In 2011, Delta began a massive fleet-renewal effort with narrow and wide-body aircraft on order. It aims to swap smaller plane for a larger one. Delta expects small regional jets will decline to about 2% of total aircraft in 2023, from 7% in 2017, and medium-size aircraft will shrink from 35% of its fleet to 15% in 2023. The benefits of migrating into bigger planes is an expectation it will lead to higher margins. However, one worries if all players do the same, its benefits will be likely best felt by its customers rather than the airlines themselves.
Delta Air Lines operates a global network that revolves around its presence in hubs such as Atlanta, Minneapolis, and Detroit. Delta commands nearly 73% market share at Atlanta, the highest share of any network carrier at a hub, and 40% of its network goes through the city, providing the carrier with lots more domestic regional traffic than peers. Delta generates a revenue premium per available seat mile due to this unique network, but also has lower unit costs when compared with other network carriers. By dominating the hub airport in Atlanta through its vast market share, Delta enjoys strong benefits from connecting this hub to other parts of the country. Atlanta is the busiest airport in the world.
Other points of note, which we found important considering Delta Air Lines as an investment are:
- Delta Air Lines is the leading US carrier in terms of airline quality rating. It leads in on-time arrivals, and loses less bags than its peers. Services all customers value.
- Bar Southwest, Delta Air Lines is the least leveraged amongst its US peers.
- Delta Air Lines is consistently one of the most profitable players in the US Airline industry.
- Delta is the only company among the four largest domestic carriers that has no Boeing 737 MAXs in its fleet.
- Delta enjoys high connectivity between hubs and regional airports, as well as a dense regional network along the Eastern coastline. It uses the route density well to enjoy economies of scale.
- It leads US airlines in terms of maintenance, repair and overhaul operations (MRO). The MRO operations provide support to over 150 third-party operators worldwide. It is the largest MRO provider in North America and the third-largest worldwide. The company projects 2019 MRO revenues of $1 billion, and forecasts $2 billion in revenue within 5 years. Delta has very wisely negotiated aircraft orders to gain further MRO contracts. This helps diversify the business and develop synergies and cost advantages
- Delta projects $7 billion in revenue by 2023 from its pairing with American Express (AXP). This compares to $4 billion in 2019. One should note loyalty program operating margins are around 60% (considerably higher than any other business line at Delta), and hence often accounts for around a third of operating income. This is also the case for a number of other airlines
Valuation and Conclusion
For Delta Air Lines, we estimate a normalised FCF margin of around 6% of revenue, based on an average operating cash flow margin of around 15%, and capex of around 8 to 9% of revenue.
Such a FCF margin would merit a valuation close to sales, which in 2019 were around $47 billion. As we write, Delta Air Lines has a market cap of around $29 billion. We think this is too large a disconnect to ignore.
Whilst we agree the Coronavirus can lead to a temporary demand shock to commercial flying, we feel Delta Air Lines’ strong balance sheet relative to peers, higher profitability relative to peers, better service relative to peers, more diversified business lines relative to peers, and a valuation that has knocked off $18 billion in a couple of weeks, offers an attractive risk/return looking to take advantage of large uncertainty pricing in a very unlikely future scenario for the US airline industry over the next 10 years and beyond.
Disclosure: I am/we are long DAL. 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.