In general, our investment philosophy is one that bypasses cyclical industries, such as energy or financials. We prefer to invest in companies with clear secular trends that go beyond economic cycles. One industry we have long avoided is airlines. Few sectors as a whole define the idea of cyclicality. This is an industry where competition for customers is fierce. It is capital-intensive. And the industry is at the mercy of the commodity markets. And yet, amidst all this, we have found a company that we think has a clear set of trends going for it. And that company is Delta Air Lines (DAL).
The airline industry has been through a tremendous amount of upheaval in the past decade, with mergers, bankruptcies, and volatile jet fuel costs providing a constant source of drama. Over the past year, however, Delta has fared better than many of its peers, with the shares down just under half a percent.
At this point in time, we think an investment in Delta is a sound idea, and break down our bullish thesis below. Before we do that, however, we will provide a brief overview of Delta's financials and how it compares to its peers (peer data is as of the close of trading on May 7, 2012).
Delta Financial Overview
|Q1 2012||Q1 2011||2011||2010|
|Revenue||$8.413 Billion||$7.747 Billion||$35.115 Billion||$31.755 Billion|
|Passenger Load Factor||79.7%||76.4%||82.1$||83.0%|
|Passenger Mile Yield (cents)||16.67||15.32||15.7||14.11|
|Average Fuel Price per Gallon||$3.26||$2.85||$3.05||$2.33|
*Non-GAAP EPS includes mark-to-market adjustments on fuel hedges settling in other periods, as well as restructuring
Airline Sector Overview
|Delta||United Continental (UAL)||Southwest (LUV)||JetBlue (JBLU)||U.S. Airways (LCC)|
|Market Capitalization||$9.5 Billion||$7.8 Billion||$6.3 Billion||$1.4 Billion||$1.8 Billion|
|Sales per Employee||$447,940||$425,320||$344,950||$321,210||$354,750|
Based on these metrics, Delta is at the high end of the airline sector. It appears undervalued on a PEG basis, and has an unassuming valuation. That, combined with the catalysts we see, makes us bullish. We now turn to the underlying arguments supporting our bullish thesis.
The Trainer Refinery Purchase: A Changing Cost Structure
On April 30, Delta announced that it would be purchasing the Trainer refinery complex from Phillips 66 (PSX) (the spinoff created from ConocoPhillips (COP). Delta is paying $150 million upfront, and will be investing $100 million more to maximize jet fuel production at the refinery. According to Delta, the move will shave $100 million off 2012's fuel bill, and will save the company $300 million in annual fuel expenses, which is equivalent to around 35 cents per share in annual cost reductions (based on Delta's 849.64 million outstanding shares).
Delta's move to acquire this refinery, which would meet 80% of its domestic jet fuel needs has provoked a good deal of skepticism, both here on Seeking Alpha and the broader investment community. On the surface, such skepticism seems warranted. The refining industry suffers from chronic losses, even more so than the airline industry. Even the best companies in both sectors struggle to maintain consistent profitability. The refining industry has been crushed by soaring prices for crude oil feedstock, waning demand, and intense foreign competition. Already, a quarter of the East coast's refining capacity is idle. Furthermore, the chemistry of refining is very exact, and Delta will end up with a host of other fuels on its hands in addition to jet fuel. In addition, merely owning the refinery does nothing to protect Delta from high jet fuel costs. The dollar that Delta saves in buying fuel from the refinery is a dollar less the refinery earns, making it a zero-sum game.
And yet, we believe that Delta has made a shrewd move in purchasing the Trainer refinery, thus making it the first airline to directly own a refinery. This move is a smart strategic decision for several reasons.
- Defend against expensive imports: According to sources involved in the bidding process, Delta was the only bidder that wanted to actually keep the refinery online. The other bidders wanted to shut it down and convert it into a terminal, a move that may have cut jet fuel capacity on the East coast by up to 20%, forcing Delta to import jet fuel at higher prices.
- Changes in Delta's hedging structure: Most airlines choose to hedge the risk of price spikes in the cost of jet fuel, which is their biggest operating expense (fuel accounted for 27.8% of Delta's operating costs in the first quarter of 2012). Furthermore, the hedges used by airlines are imperfect. They work only when prices rise or fall according to company expectations. The unprecedented volatility seen in recent years in the financial markets has defeated even the elaborate hedging strategies used by Delta and other airlines. With the purchase of the Trainer refinery, however JPMorgan (JPM) has agreed to finance the refining process, including the buying and selling of crude and jet fuel, which can add another layer to Delta's defenses against cost fluctuations.
- Strategic location: Delta has been aggressively expanding its presence in the New York area. In 2010, government data shows that over 61,000 Delta flights departed from New York airports, placing Delta behind only United. And that figure is set to rise. Delta is expanding operations at LaGuardia, and is investing $1.2 billion into its expansion at JFK. As these upgrades and expansions are complete, Delta's need for jet fuel on the East coast will rise. Shutting Trainer would put a damper on that, as it is configured to produce twice as much jet fuel as the average East coast refinery. The Trainer complex can produce up to 23,000 barrels of jet kerosene per day, which amounts to about a fifth of the region's total output. Shutting the refinery would force Delta to import expensive crude from abroad to meet its needs.
- Lowered input costs: In 2010, Trainer's last full year of operation, 75% of the oil it imported was sweet crude from Africa, thus adding huge costs to its import bill. Under Delta, the refinery's cost structure will change. BP will supply the crude oil needed, and in exchange Delta will give BP all of the non-jet fuel products the refinery produces in exchange for jet fuel from BP and Phillips 66 across the country. Furthermore, sources close to Delta say that the airline plans to further reduce the refinery's cost structure by moving oil from North Dakota and the Bakken shale to New York by train and then moving it down to the refinery. Because it is landlocked, light sweet Bakken crude is trading at a $20 discount to Brent. Thus, Delta will be able to extract more cost savings from the deal.
We believe that the criticism surrounding this deal is unwarranted. It is a mistake to assume that Delta sees this as the solution to controlling jet fuel costs. The truth is that there is no perfect solution to controlling jet fuel costs. This move by Delta is just one part of an overarching strategy. The crack spread in Delta's fuel costs is something that is very difficult to hedge against, and the $300 million in annual savings Delta expects to generate from this move will quickly begin to add up. CFO Paul Jacobson says that he expects the deal will be accretive to Delta's earnings in the refinery's first year of operations. The Trainer refinery is an ideal fit for Delta because it is close to the company's New York hubs. In addition, the argument that this is a poor deal because Phillips 66 did not want Trainer is flawed, in our opinion. The refinery did not fit into the company's corporate strategy of focusing on large refineries in other regions of the country. Delta has brought in Jeffrey Warmann, a refining executive from Murphy Oil (MUR) to run the Trainer plant. We believe that the true benefits of this deal will begin to be seen in 2013, and that the transaction will indeed be beneficial to Delta.
Delta's Financials: Healing the Wounds
Delta is slowly but surely recovering from its bankruptcy, and the company is aggressively moving to heal its balance sheet. CEO Richard Anderson is committed to retiring debt, and has publicly stated that out of every $2 of cash the company generates, $1 will go to investing in the business, and $1 will go to retiring debt. Over the past year alone, Delta has retired over $2 billion of debt, and it expects to reach $10 billion of net debt by 2013.
Delta reported $831 million of operating cash flow in the first quarter of 2012, a 5.46% improvement over 2011 levels. It is important to address the matter of Delta's book value. At the end of the last quarter, Delta had a book value of negative $1.011 billion. How can this be? Delta's negative book value is due in large part to the huge losses the company sustained in 2008 and 2009, an issue that impacted not only Delta, but other companies in this sector as well. Delta, however, has taken longer to return to positive book value than some of its peers. For the sake of comparison, we provide the book values of Delta and its peer's below (figures are taken from the most recent 10-Q filings).
Airline Book Values: Q1 2012
|U.S. Airways||$0.2 Billion|
Delta's negative book value is a legacy of its bankruptcy restructuring process, which occurred later than that of its peers. United filed for bankruptcy in December 2002. U.S. Airways filed for bankruptcy in August 2002, and again in 2004. Delta, however, filed for bankruptcy in September 2005, and as a result it has had less time to repair its balance sheet from the bankruptcy process than its peers. As Delta reports sustained profits, its book value will enter positive territory. Delta expects Q2 2012, as well as full year 2012 results to be "a significant improvement over last year, despite higher fuel prices."
Insider Transactions Show No Cause for Concern
The role that insider transactions have in predicting future performance can be debated endlessly, and it is beyond the scope of this article. Barron's reported on Monday, May 7 that Delta CEO Richard Anderson had sold 175,000 shares of Delta stock, netting him almost $2 million. While this may seem to be cause for concern on the surface, we do not see it that way. This was his first transaction since May 2010, and he was granted 357,800 shares in February. It is important to note that he kept a majority of that stock grant. Had Anderson been bearish on Delta stock, he would have likely sold all of his shares. Not every insider sale is cause for concern. Corporate executives are human, after all, and they have a lifestyle to finance. It is unreasonable to want every executive to keep every share that they have ever received because it will go up in value. The only way to monetize their stock awards is to sell them. In addition, as Anderson was selling Delta shares, one of the company's directors was buying them. Delta director Paula Reynolds bought 10,000 shares on May 2, marking the first purchase since Delta exited bankruptcy in 2007.
Delta Air Lines is not a company we thought we would ever invest in, but the purchase of the Trainer refinery, as well as the company's improving financials have made it a company with a secular catalyst, exactly the kind of company we look for. We have initiated a position in Delta in the last several days, and anticipate holding it for some time as the full benefits of the company's recent initiatives are realized. We believe that investors who add to or initiate a position in Delta at this time will be rewarded for their beliefs. Analysts agree. The Reuters average price target for Delta currently stands at $15, implying upside of 34.29% as of this writing. EPS is expected to reach $2.26 in 2012 (and $2.57 in 2013), up over 60% from the $1.41 (non-GAAP) that Delta earned in 2011. We believe that Delta is poised for success in 2012 and beyond, and recommend that investors buy in at these levels.
Additional disclosure: We are long JPM via the SPDR Dow Jones Industrial Average ETF.