Why do investors invest in companies? Simply, to make a premium return on their investments. The airline industry is one of the riskiest investments available and should, in theory, provide a large risk premium to its investors. This report continues the analysis of Delta, and the airline industry's, historical market performance, factors influencing their profitability, and provides an analysis on recent market returns.
The airline industry has gone through severe changes in the past decade, to say the least. Markets domestic and abroad have experienced shockwaves from events affecting the financial markets globally. Since the airline industry is so dynamic and strongly affected by events spanning the globe, it's best to cover some of these events which have had a major impact on airlines, especially in the past five years.
U.S. recession of 2007
It's amazing how something like the unchecked securitization of mortgage-backed securities has had such a tremendous effect on the airline industry; even though, on face value, there seemed to be little, to no, connection between air flight and mortgage-backed loans. The recession was officially announced on December 2008 as unemployment began rising and the economy began contracting. The unemployment led to a severe reduction in discretionary income throughout America, and eventually to foreign nations as its effects began toppling economies.
The airline industry struggles with highly elastic demand. Not only are consumers highly price elastic, but their demand for air travel wanes very quickly amid even a possible future economic slowdown; making recessions absolutely catastrophic to airline profitability, and especially to Delta (DAL) who emerged from bankruptcy in 2007. By year end 2007, Delta experienced $1.61 billion profit, with free cash flows of $323 million. In contrast, by year end 2008, Delta experienced net losses of $8.92 billion, with free cash flows of -$3.2 billion. It's also interesting to note that by December 31st, 2008, Delta's shares closed at $11.46, while their net losses for the year were $19.08; essentially making the share worthless.
From late December 2011 to April 2012, the markets experienced a tremendous rally. Optimism of the U.S. and global economies strengthening blinded consumers with euphoria. The S&P rose 14%, DOW rose 10.3%, and Nasdaq rose an incredible 17.8%; however, these numbers were dwarfed by how well airline stocks rallied in those months. Just in the same months of December-April, Delta rose 24.2%, and Delta rose a total of 31.3% from December-June; however, we've seen extreme price volatility due to issues stemming in China, India, Europe, and America. Though, overall, the airline industry has performed extremely well recently, it has gone through a rollercoaster in the stock market with news of China's contracting GDP, Europe's economic crisis, and America's unstable economy. The following figure illustrates Delta's market performance over the past year (Yahoo Finance). Note, though, how the stock experiences periods of rapid price appreciation and sudden drops, representative of highly uncertain, fearful, and even uneducated investors.
Oil Refinery / Crude Oil
On April 30th, 2012, Delta announced a widely controversial acquisition, spurring the boots of analysts and investors across the board. To hedge against high jet-fuel costs, Delta said it would spend $150 million to acquire ConocoPhillip's (COP) oil refinery and spend another $100 million to renovate the plant to produce more jet fuel. Apparently, from the statements of Delta's CEO Richard Anderson, the investment will be a homerun. Projections estimate that the investment will save Delta $300 million annually on fuel expenses, which will practically pay for itself in just one year. According to a filing, achieving similar saving measures by purchasing more fuel efficient Boeing 737's would sum to upfront capital investments of $2.5 billion. This sort of vertical integration, especially in the airline industry, has been titled as an innovative approach to reducing fuel costs; allowing Delta to transfer the profits, which would have been realized by the oil refinery, to its own bottom-line. Still though, Delta needs to complete making changes to the refinery before reaping its benefits, which should be ready by the end of the third quarter.
In an efficient market, we'd expect the markets to react instantaneously to news: quickly reflecting the positive or negative effects to the company's value. What we experienced with Delta was actually quite troubling. In spite of this good, even great, news, Delta's stock didn't budge one bit; in fact, it traded lower on the following day, and experienced a 10.5% loss in the following 3 weeks. Although this sort of devaluation was unexpected, it still reflects a rational perspective in part by investors. At the time, many were incredulous to Delta's acquisition and ability to successfully operate the refinery in a profitable manner. In a very strategic move for the markets, and for business, Delta re-hired approximately 400 employees previously working at the refinery; bringing experienced management into a completely new sector for Delta.
Although Delta has taken steps in building investor confidence for its decision to acquire the refinery, one question is still burning through Delta's smoke and mirrors: how can Delta turn a profit when ConocoPhillip's, an expert in the industry, couldn't even turn a profit on the refinery? Undoubtedly, ConocoPhillips considered every option available to them before closing the refinery, but, in the end, still closed it down to avoid future losses. From an investor's perspective, they have every right to be incredulous against Delta's acquisition. In comparison, if a surgeon couldn't revive a patient, then how could a monkey do it?
The global economy is currently a mixing pot of bad and good news. There's no real definitive answer yet of which direction it's headed towards. Reports indicate contracting GDP growth for China, while others report on China heading towards 10% export growth in 2012. America has seen reports of rising unemployment, but also reports of increased home sales. The overall picture is unclear. On one hand we get good news, while on the other hand we get bad news. The problem comes from an inability to combine all these contradicting reports to really understand what's going on. Consequently, we've seen a rollercoaster in the equity, bond, and commodity markets.
On July 2nd, 2012, crude oil prices were at $82.63, representing a 24.7% drop from February. The market greeted this news with caution because it serves as a double-edged sword. On one hand, lower crude oil prices translates to cheaper jet fuel which will increase profitability for airlines; however, on the other hand, crude oil prices dropped significantly because economies are preparing for a possible upcoming economic slowdown. So, even though oil prices are down 24.7%, it comes with the bad news of decreased foreseeable economic activity and, since consumer demand for air travel is highly elastic, it translates to an adverse effect on demand for airlines. Investors have acknowledged this fact for Delta, United Continental, and even Southwest airlines, as represented by their stock's price movement.
Since March, Delta, United Continental (UAL), Jet Blue (JBLU), and Southwest (LUV) performed very well, even amid violent stock movements. The "worst" performers were Southwest and JetBlue, appreciating about 3.6%, while the best performance belonged to United Continental, appreciating 20.5%. For investors in airlines, the sudden crude oil price drop couldn't have come at a more opportune time. Airlines are currently experiencing their peak flying season which will go on throughout around August; with peak demand and relatively low jet fuel costs, it will increase Delta's bottom-line profitability unless, however, consumer demand decreases too much in fears of a global economic recession.
In the end, is it really worth investing in airlines? For all the risk placed on the stockholders, how much of a return do they really make, especially when compared to safer, diversified indexes like the S&P 500? In analyzing Delta's returns, we'll take several approaches in gauging its plausibility as being a 'good' investment.
In calculating Delta's 2 year expected market return, we'll be utilizing the Capital Asset Pricing Model. We're utilizing the following assumptions: Beta of 0.7 (eTrade), risk-free rate of 0.62% (2-year note on June, 2010), and a 2-year market return of 33.1% (S&P 500). By the CAPM method Delta's expected rate of return should be:
1.24% + 0.7(33.1%-1.24%) = 23.54%
We can conclude that Delta's expected 2-year return since June, 2010, as calculated by the capital asset pricing model, should have been 23.54%.
Historically, Delta hasn't issued dividends, making the only gain from the investment through capital gains. Had an investor invested 24 months ago, they would have lost 6.1%. These figures exclude devaluation from inflation, which represents an even steeper loss.
Expected vs. Reality
What we've experienced is something quite troubling. Whereas Delta's market performance should have been a positive 23.54%, it actually devalued by 6.1% over the 2 years, representing a steep 29.64% spread. What exactly does this 29.64% spread represent though? Well, many things. It indicates that even though investor confidence has been restored in many sectors, they're still skeptical about investing in the airline industry. Investors have not received returns far beyond market returns to compensate them for the immense risk they've taken on, and also, to make things worse, their investments significantly underperformed the entire market. So, from a historical perspective, when positioned against the market, Delta's stock underperforms, yet places an immense burden of risk on the investor, currently making this investment terrible in the long term.
In contrasting Delta's 5-year market performance to its peers JetBlue , United Continental, and US Airways, Delta performed on par relative to the industry, with US Airways performing the worst. However, in drawing a 1-year market performance, US Airways significantly outperformed its peers, primarily in part to speculations regarding acquiring American Airlines.
One of the best ways to benchmark a stock's performance is against a very large index, like the S&P 500 or DOW. In analyzing Delta's performance, we would hope to see it perform at least on par with these indexes; however, accounting for the immense risk associated with airlines, we would actually expect a large risk premium to compensate investors for the additional risk they've taken on. Unfortunately though, Delta's stock performance over the past 5 years has been quite troubling, as seen from the following chart taken from eTrade:
Whereas the Dow and S&P 500 are nearly at the positions they were before the financial market collapse, Delta Air Lines has experienced tremendous devaluation. Over the past 5 years, the Dow is down 7.7%, S&P down 12.4%, but Delta Airlines is down a tremendous 46.4%. There are several factors influencing not only Delta Airline's tremendous devaluation, but that of the entire airline industry.
Historically, labor expense was consistently the airline's largest operational costs, with fuel expense situated as the second largest expense. Not in the past decade though. Last quarter, fuel expense comprised 27.8% of total operating expenses, up from comprising 23.1% of total operating expenses in the same quarter of 2007. Also, fuel costs, as a proportion of total revenues, increased from 22.2% in 2007 to 26.5% in 2012. We did experience a 103% increase in revenues, but also experienced a disproportionate 143% increase in fuel expenses, largely attributable to the increase in fuel prices over the year. The effects of volatile fuel prices are blatantly apparent in its ability to suck out nearly all profitability in airline transportation. We've seen jet fuel prices rise from just $2.10/gal in June 2007 to $2.97/gal this May, representing a 41.4% increase in an operational cost which historically used to be stable.
In recent events, crude oil prices have dropped as negative sentiment has begun penetrating global economies. On June 26, 2012, reports of consumer confidence declining from 64.4 in May, to 62.0 in June, spread across the media, further inducing negative sentiment. Demand for oil has dropped globally, corresponding to a significant drop in prices. On face value, this is beneficial to all airlines, as it helps them lock-in cheaper fuel prices through hedging, thus lowering their largest operational cost. This will help improve top and bottom-line profitability if, and only if, air travel demand remains constant. It's highly preferable for airlines to fly with high capacity on the planes, but because of the airline industry's business dynamic, they'll be forced to fly with lower passenger load factors, even at unprofitable levels. It's likely that demand for air travel will decline in anticipation of a future economic pullback, which may actually decrease airline top-line profitability, even amid lower operational costs. If so, this may be absolutely disastrous to an airline's bottom-line profitability.
Since 2007, airline profitability has been ravaged by highly elastic consumer demand coupled with rapidly rising operating costs. As consumer demand for air travel fell, airlines were forced to reduce their airfare, amid rapidly rising fuel costs. Intense competition from pre-consolidation led to price wars by slashing top-line and bottom-line profitability. U.S. unemployment has been decreasing and we've seen some light at the end of the tunnel, however, the global economy is speaking a different language.
The media has had a heyday in blowing up the current global economic situation, which has translated into mass investor panic and highly volatile markets. Since investors are rational, at least theoretically, they've pulled away from equity markets and seeked refuge in the risk-free Treasury bond markets. What we've seen in the past five years has been evident of this fact; with 30-year Treasury notes yields dropping from 5.2% in June 2007, to an anemic 2.34% in June 2012. While we've seen Treasury yields fall to lows, the equity markets have, overall, rebounded to about 85% of their 2007 levels, while companies like Delta are still down 46.4%. I see a very interesting picture from these facts. In the past 3 years, investors have regained confidence in the markets, until recently though. We've seen the S&P 500, Dow, and Nasdaq drop from their heights in April as fear of the global economy crippled investor confidence. We've experienced something very interesting though with airline stocks since April. Whereas the overall market sectors have dropped since April, airline stocks have stayed roughly near the same level, and on Delta's case, even appreciated amid the barrage of bad economic news. It may very be that investors have "baked in" the reduced operational costs associated to jet fuel as countering the decreased revenue.
In 2007, Delta announced its proposed acquisition of Northwest airlines, which was finally concluded in 2008, making Delta the largest airline at the time. Delta's acquisition of Northwest was met by anti-trust opposition from air travelers, but the case was thrown out by federal regulators claiming "the proposed merger between Delta and Northwest is likely to produce substantial and credible efficiencies that will benefit U.S. consumers and is not likely to substantially lessen competition" (msnbc). The merger would broaden Delta's flight routes and supposedly provide $2 billion in cost synergies. So far though, from what we've experienced, the cost synergies haven't come through from the merger.
In analyzing the operational cost efficiency of Delta's merger with Northwest, we'll look at Delta's operating cost per available seat mile prior to, and after, the merger. We'll also compare figures in which Delta's largest operational cost, jet fuel, is nearly the same throughout both years. As taken from Delta's 10k report:
Notice how in year-end 2006, Delta's operating cost per available seat mile was 11.80 cents, with the average price of fuel being $2.12. Now we'll look at Delta's 10k report again to analyze its operating cost per available seat mile. The most comparable year would be 2009 (illustrated in the following figure), which serves as a post-merger year, and also a year with very similar average fuel costs of $2.15. It's interesting how after the merger, Delta's operating cost per available seat mile actually increased by 4.4%, despite a negligible increase in jet fuel, which would have only impacted the total operating cost by 0.37%.
Although we've heard much talk of cost synergies through the merger, we haven't seen much definitive proof of such; in fact, from a pre-merger to post-merger analysis, with fuel price as a relative constant, we've seen a decreased ability to manage operational costs; so, in fact, we've seen a reverse effect, making Delta less efficient.
There's another very interesting calculation, called the CASM-ex, or CASMex, which is a more definitive tool than the traditional Cost per Available Seat Mile. It's a metric used to track operational efficiency, excluding the cost of fuel volatility and other special items. Essentially, it tracks Delta's own performance in managing its operational costs; however, they've only recently begun utilizing this metric, so we can go as far back as 2010:
For year-end 2010, Delta's CASM-ex was 8.27 cents, which increased to 8.53 cents in 2011; a 3.14% increase in CASM-ex. This increase is directly attributable to Delta's management of cost efficiency which, even after the merger, has been lacking. We also looked at Delta's CASM-ex of last quarter and juxtaposed it to the same quarter of the previous year. What we saw wasn't very comforting. For the first 3 months of 2011, Delta's CASM-ex was 8.96 cents, which increased to 9.28 centers in the same months of 2012; representing yet another increase in operational costs of 3.6%. The merger with Northwest has definitely grown Delta to becoming an impressively large airline in terms of routes, operating fleets, and revenues, but unless Delta can actually manage its company properly, then it can never manage its costs.
Market Performance Consensus
Ultimately, as with any stock, Delta's market performance has been extremely volatile; leading some investors to make big gains, while others are left with nearly half of their initial investment. When juxtaposed against the market, Delta outperformed every index in the past six months; however, it has shown extremely weak performance from a historical 2-5 year outlook. To make things more difficult for investors, issues surrounding Delta's market performance are complex, variable, and rapidly changing. Although crude oil prices have dropped significantly in recent months, issues revolving the global and domestic economy have clouded the outlook for the airline industry. With such razor-thin profit margins, even the slightest dip in revenue will have a traumatic effect on Delta's bottom-line, leaving weary investors by the sidelines. Also, a possible sign of Delta's 5-year market underperformance may stem in its inability to reward investors for the extremely high risk they've taken by investing. Not only has Delta's stock underperformed historically, but it's lagging far behind the S&P 500's performance, which experiences much less market risk than the airline industry. All in all, Delta has taken measures in increasing its revenues by focusing on its customer's experience, while taking measures to decreasing its operational costs. This paints a positive outlook for Delta during an economic rebound, which will lead to very strong future market performance once the economy rebounds.
Delta, like many airlines, has come a long way since its origination, coming quite far from a crop dusting company. The past decade has been, nonetheless, a rollercoaster for the entire industry. With jet fuel prices skyrocketing past $140/barrel in June 2008, many airlines experienced tremendous, multi-billion dollar losses, and to make things worse, some even hedged fuel at $140 right before it plummeted 73.1% to $37.71 in merely six months. To make things more complex, Delta's customer demand is highly elastic, reacting strongly to the perception of the economy. In the past decade, the 9/11 terrorist attacks and two recessions have been absolutely devastating to Delta's bottom-line profitability, strongly influencing its bankruptcy in 2005 and merger in 2008. Delta has taken progressive steps to reducing its costs, arguing that a merger with Northwest would provide cost synergies, and its acquisition of the oil refinery would help them save $300 million annually. They've also made significant capacity adjustments, primarily from codesharing in their SkyTeam alliance.
One thing is certain: Delta has made changes. The burning question that remains is whether or not those changes were successful. SkyTeam's strategic alliance has helped tremendously in increasing passenger load factor, improving both top-line and bottom-line profitability. Unfortunately, although Delta had spoken so highly of its merger with Northwest, we still haven't seen much cost savings; in fact, their cost per available seat mile, excluding jet fuel and other special items, has increased year-over-year and quarter-over-quarter. Some say bigger is better, but in this case, bigger is merely more difficult to manage. Finally, Delta claims that the benefits from acquiring the oil refinery will begin in the third quarter, leading many to speculate on its actual effectiveness.
For now though, Delta is at least directing its energies to the right goals: increasing revenues, while decreasing costs. They've begun focusing more on the customer, already launching a $2 billion effort directed to improving the customer experience. Even though the outcome of the oil refinery is yet unclear, it shows progressive thinking in reducing operational costs in the right way: not through decreasing the customer's experience. With Delta's high fixed cost structure, high passenger load factors, and shift towards reducing operational costs, they're positioned well for a post-consolidated industry. With stronger pricing power through consolidation, and hopefully increased demand from economic growth, Delta may actually provide premium returns to its investors.