Economic turbulence and unions have been ravaging airlines for some time now. Despite headwinds galore, however, Delta (DAL) represents an incredible value play with its near "strong buy" rating on the Street. Analysts have raised estimates considerably of late as expectations of strong fourth quarter progress get closer to materializing. While Southwest (LUV) is also skewed more towards reward than risk (see here), investors do not fully recognize how little the multiple needs to expand for its competitor to grow shareholder value.
From a multiples perspective, Delta is at a bargain level: 3.7x forward earnings. Southwest trades at a respective 40.6x and 10.7x past and forward earnings. Between these two is United Continental (UAL), which trades at a respective 12.7x and 3.4x past and forward earnings. The company is rated a "strong buy", but had 11 of the 12 revisions to estimates go down. Delta's Gross margins are also low at 7.8% compared to 16.4% for United Continental (UAL) and 21.1% for the always-operationally strong Southwest. Accordingly, Delta has substantially room for improvement and trimming SG&A.
At the third quarter earnings call, Delta's CEO, Richard Anderson, highlighted successful results:
"Delta earned a $765 million profit for the September quarter with an operating margin of 11%. We offset the majority of this quarter's $1 billion increase in fuel price with a 10% increase in top line revenue.
Delta's overall capacity was down 1% in the quarter. We experienced strong demand, particularly from corporate customers, which drove our unit passenger revenues up 11% from prior year. We continue to see strong demand in the fourth quarter.
We ran a good operation with top tier operational performance in baggage service on-time completion factor, which resulted in a 40% reduction in DOT compliance year-on-year. As a result, Delta people earned $15 million in shared rewards for the quarter…
And while we're pleased with this quarter's performance, we have much work ahead".
This is now the second consecutive year that Delta has had solid profitability amidst high fuel prices and macro headwinds. Management is emphasizing capacity efficiencies and has indicated success by reducing the size of 50-seat fleet aircrafts by 33% and rising. Although the market is not particularly bullish about aircraft mergers, I see the control of Northwest as a logical step towards better pricing power. As commodity volatility hinders investors entry, it is critical that airlines focus also on the revenue-side. Several unions have fallen into bankruptcy and reduced costs that way, so the pressure is certainly on finding other measures to grow margins.
Perhaps most important for retail investors will be the fourth quarter earnings result. The top-line has been reportedly progressing better than expected, buoyed up by solid demand in key areas. Going forward, Asia is expected to have high GDP growth while CASM ex-fuel will go up around 2-4% this year as a result of labor and scaling up.
Consensus estimates for Delta's EPS are that it will decline by 22.8% to $1.32 and then grow by 74.2% and 19.6% in the following two years. Assuming a multiple of 6x and a conservative 2012 EPS of $2.14, the rough intrinsic value of the stock is $12.84, implying 54.3% upside. Even if the multiple were to be only 4x and 2012 EPS turns out to be 11.7% below consensus, the stock would barely fall. Note also that of the 14 revisions to estimates, all have gone up for a net hang of 7.8%. Accordingly, I view Delta as one of the strongest investments right now, especially in the event of a recovery.
Another strong airline is Southwest. The company is one of the only major airlines that did not declare bankruptcy and it has been profitable for nearly 4 decades. It has an investment grade rating and a top brand name in the industry. With that said, third quarter results were down 37% y-o-y and challenges in integrating AirTran loom considering labor costs. AirTran is being downsized and will cut back on key areas, like Boston, Philadelphia, and Orlando in 1H12.
Consensus estimates for Southwest's EPS are that it will decline by 44.6% to $0.41 and then grow by 97.6% and 33.3% more in the following two years. Assuming a multiple of 14x and a conservative 2012 EPS of $0.76, the rough intrinsic value of the stock is $10.64, implying 24.9% upside. Analysts currently rate the stock a "hold" - a sentiment that I agree with given the preferability of Delta.