Ratings Agencies Miss Delta's Flight To IG

| About: Delta Air (DAL)

Summary

Delta Air Lines’ credit risk is materially overstated by CDS markets and overstated by Moody’s.

CDS is at 305bps, compared to an Intrinsic CDS of only 131bps.

Moody’s Baa3 rating is four notches too low, given Delta Air Lines’ investment grade cash profile.

Moody's rates Delta Air Lines, Inc. (NYSE:DAL) with a cross-over Baa3 rating. However, Valens rates DAL with an upper medium investment grade IG3 credit rating, or an A2 equivalent using Moody's ratings scale. DAL's combined cash flows and cash on hand comfortably outstrip all of their upcoming obligations, including their many debt maturities, driving a rating four notches higher than Moody's.

CDS markets are also materially overstating DAL's credit risk, with CDS at 305bps relative to an Intrinsic CDS of only 131bps.

Cash Flow Profile

Below, we've included our Credit Cash Flow Prime™ chart for DAL. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. By using Uniform Adjusted Financial Reporting Standards based metrics, it shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (UniformFRS adjusted cash flow number) expected to be generated based on consensus analyst estimates and Valens Research's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.

The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.

Click to enlarge

If the company generates and has cash levels that are above their obligations, the risk of default is extremely low. Even if the cash generated yearly is close to the levels of the stacked bars, a company generally has the flexibility to defer payments of various kinds. For example, they can allow assets to age a little longer, or they can cut certain maintenance costs such as maintenance capex. While decisions such as those can create other business concerns, the issue in credit risk is simply this: Does the company have enough cash to service their credit obligations?

DAL's cash flows comfortably exceed all obligations, including debt maturities that range from $264mn-$2.1bn, through the next seven years. In addition, their current cash on hand stands at $3.4bn, and is expected to build going forward. Thus, the firm should have no issues handling all their obligations even if cash flows were to dip.

Management Incentives

Like most people, senior executives and board members do what they are paid to do. This is why DAL's Form DEF 14A is key to understanding this company's fundamentals, something that credit agencies seem to be missing. Valens' Incentives Dictate Behavior™ analysis focuses on DAL's senior executive compensation and governance. This analysis is meant to help investors understand corporate governance, how aligned a management team may be with shareholder interests, and the potential consequences of a management compensation framework to the business.

DAL's management compensation framework shows positives for credit holders. Management's short-term compensation is based on pre-tax income, the meeting of monthly reward and carrier goals, and total revenue per available seat mile (TRASM). Meanwhile, management's long-term compensation is based on operating income margin, ROIC, and domestic and international customer service performance.

DAL's compensation metrics incentivize management to focus on all three value drivers: expanding margins, improving asset utilization, and revenue growth. The pre-tax income metric should drive management to improve margins and increase revenue, while the TRASM metric likewise encourages top-line growth as well as Asset' Turns improvement. The emphasis on margin enhancement is reinforced by other metrics: operating income margin, customer service performance, and ROIC. In addition, the customer service metric should drive top-line growth while the ROIC metric focuses on improving asset utilization levels.

Overall, DAL's compensation framework is designed to expand UAFRS-based ROA, which should lead to increased cash flows to service all their obligations.

Management Representations

Valens provides analyses of companies' statements on earnings calls, termed Earnings Call Forensics™. This analysis is meant to help assess a management team's confidence in their conference calls when discussing certain areas of the business such as operations, stability, strategies, their ability to manage business risks, and especially, their liquidity and solvency.

The analysis of DAL's Q4 2015 earnings call (11/13) highlighted highly questionable markers from management. Management appears concerned about the sustainability of their year-over-year pre-tax profit and their ability to meet Q1 2016 free cash flow guidance. They also appear to be exaggerating their operational performance and its effect on customer satisfaction results. They may be concerned over whether they will be able to make immediate returns on their increased stake in Aeromexico. DAL management may likewise be concerned about pricing pressures from lower fuel costs, and over FX headwinds continuing to eat into revenues.

While management appears concerned over revenues and cash flows, DAL's ability to service all its obligations is supported by its substantial cash on hand and expected cash build. That said, these are concerns that credit holders should nonetheless take note of.

Conclusion

Ultimately, a company's credit risk (or lack thereof) is driven by cash available against cash obligations. DAL's credit risk is being materially overstated by CDS markets and overstated by Moody's, considering their cash on hand and cash flows that cover all their obligations. DAL's credit ratings are expected to further improve, and CDS spreads should tighten once the company's credit risk profile is correctly recognized.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Rafael Formoso. Professor Litman is regarded around the world for his expertise in forensic accounting and "fundamental forensic" analysis, particularly in corporate performance and valuation.

Disclosure: I am/we are short 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.

Additional disclosure: Officers of Valens Research are engaged and have beneficial interest in an investment management company, Kennebec River Capital, which has positions in the equity of Delta Air Lines, Inc. (DAL) as of the date of this report.