- With a return of 116.97% over the past year, Delta Air Lines (DAL) has shown great earnings growth and superior profit margins to its competitors.
- However, the company's lower cash ratios and high debt levels relative to its peers questions the sustainability of such high returns.
- With the threat of rising oil prices, investors should view Delta Air Lines as a trade rather than a long-term investment.
In the past year, returns for the airline industry as a whole have been phenomenal, and no less so for Delta Air Lines (NYSE:DAL) with a 1-year return of 116.97%. In addition, the company has seen vibrant earnings growth, having beaten estimates in the past five quarters. Rising passenger numbers, and until recently, lower fuel costs have provided a much needed boost to the airline industry, with competitors such as United Continental Holdings (NYSE:UAL) and Southwest Airlines (NYSE:LUV) posting a 1-year return of 40.12% and 101.70% respectively.
With Delta trading at all time highs, one has to ask if the surge can really continue. In a previous article, I argued that Delta's low P/E ratio coupled with its vibrant earnings growth made the stock a clear buy. Here, I revise that argument somewhat. For investors looking to get in on Delta's earnings growth, I believe they can still do so. However, the stock is not "buy and hold" in my opinion. Investors looking to profit from such a trade would need to be very proactive as to when they enter and exit the stock, especially when one considers the danger of rising oil prices.
Financial Ratio Analysis
From looking at the profitability ratios of Profit Margin, Operating Profit Margin and ROE, it is clear that Delta excels over competitors United and Southwest Airlines in this regard. However, we can see that when it comes to liquidity and solvency measures, Southwest Airlines seems to be the best performer. The favourable environment for airlines seems to have benefited Delta the most in terms of profit margins - the company appears to have been successful at keeping costs low and increasing passenger numbers. With high debt loads across the airline industry in general, sustaining high profit margins to adequately cover costs appears to be the lifeblood of the airline industry. Of course, this is true across all industries, but it would appear especially so in this instance.
However, the company has quite a high debt to equity ratio of 100.62 and when we look at the firm's current, quick and cash ratios, the firm's cash position is inferior to its peers. In this regard, a shift in macroeconomic factors such as rising oil prices or declining passenger numbers (or indeed both) could turn the tables for Delta quite quickly. Indeed, there is a risk that with the recent rise in oil prices the airline industry could be in for a significant downturn. So, what can we expect over the coming quarter, and how will Delta be affected if oil prices continue to spike?
Using regression analysis, I decided to use a log-log regression model to compare the daily returns of Delta Air Lines against the daily price movements of Brent Crude Oil, with Delta's returns as the dependent variable (NYSE:Y) and Brent Crude Oil Prices as the independent variable (NYSE:X). The regression output from R Studio is available here, and the two regression equations test negative for heteroscedasticity and serial correlation.
Delta Daily Returns (%) = 0.0003832 - 0.0613406Brent
p-value of Brent Crude Oil variable = 0.174
This regression tells us that for every 1% increase in Brent Crude oil prices, Delta's returns decrease by 0.06%. However, note that with a p-value of 0.174, our t-test is insignificant at the major levels of significance. Therefore, we cannot reject the null hypothesis and thus cannot conclude with a degree of certainty that oil price rises cause a sudden drop in Delta's returns over the same time period. Indeed, we have seen that in the past few months, while oil prices have risen, Delta's returns have risen to an even greater extent - economic growth has been a greater determinant of returns than oil prices per se.
To account for potential time lags in our analysis, I use an autoregressive lag model (with our dependent variable placed as an independent variable with a three-month time lag), I run the regression again to test if the effect of oil prices on Delta's returns are indeed lagged, i.e. the effect of a unit increase in the price of Brent Crude Oil affects Delta's returns after a lag of three months rather than instantaneously.
Delta Daily Returns (%) = 0.0003871 - 0.0842389Brent - 0.0164105Delta (t - 3 months)
p-value of Brent Crude Oil variable = 0.0746
Here, we can see that our p-value is significant at the 10% level of significance and the regression is telling us that a 1% increase in Brent Crude Oil prices would result in a 0.08% drop in Delta's returns three months later. Based on the data, there is more evidence that oil prices have a lagging, rather than instantaneous effect on Delta's returns. Therefore, it is my opinion if we see oil prices continue to rise, it is still possible that Delta can continue to provide solid earnings performance in the next quarter. However, the effects of higher oil prices could start to materialize in September and this is the time period when investors may want to consider taking profits.
To conclude, Delta's solid increase in earnings and profit margins mean that the stock could still have a good run ahead of it. However, the possibility of rising oil prices means that the run could be short-lived and I would look at Delta as a trade rather than an investment. The company's relatively high debt levels and lower cash ratios relative to its peers would prevent me from making it a long-term trade.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.