Delta Airlines: Timing is Right for a Covered Call

Delta Airlines (DAL) is expecting to lose about $0.74 per share this year - that's the consensus of the twelve analysts who post annual earnings estimates. On gross annual revenues of over $20 billion, we think it's a sympton of the hyper-competitive airline market that this company expects post a loss of a roughly $250 million. Given the current environment of not only discount competitors, but also rising fuel costs, all the airlines are in the same boat. Delta has been boosting its fuel surcharges for passengers as fast as the other majors have, including last week's +$20 bump ($10 each way) that Northwest Airlines (NWA) instituted. Sensitivity to energy prices in this industry is particularly evident in the stock charts we looked upon.

According to a Business Week article last week by Moira Herbst (May 7, 2008 issue of BW), Southwest Airlines (LUV) is the only major airline to have instituted a hedging program in its fuel buying. Delta and the other carriers all have to contend with the same problem of soaring fuel costs, and there really isn't a solution to this problem for the carriers, other than passing the costs on to the consumer via fuel surcharges. Most of the other airlines, according this this article, don't have the cash available (effectively putting money "at risk") to hedge the billions of gallons of jet fuel that they need to buy. The premiums for the call options in the energy sector have gotten prohibitive.

Delta last came out with earnings in late April, in a combined statement with NWA, saying the losses amounted to over $10.5 billion (see conference call transcript). This was a combined result of huge write-downs on the companies' values, and losses due to fuel prices. Delta's losses specifically were $6.4 billion, despite a 12% rise in sales during the quarter. Excluding a special $6.1 billion non-cash charge relating to the drop in Delta's market value due to what the company referred to as "sustained record fuel prices", the airline lost $274 million in the first quarter of '08. Delta maintains that it would have recorded the special charge in the quarter regardless of its pending merger with NWA. Post-merger, both NWA and DAL intend to reduce costs through cutting flights, capacity and jobs. Obviously, the companies unions are both interested in preserving as many jobs as possible, and federal regulators are interested as well. With its capacity reductions, Delta said it expects to be profitable in the second quarter of '08.

Delta actually emerged from bankruptcy about a year ago, with a market value of around $12 billion. Since then, the stock price has been reduced enough so that its current market cap now stands at $2.2 billion. On the balance sheet, DAL maintains $8.80 per share in cash, a total of over $2.6 billion, but that is offset by $9.1 billion in debt. Operating free cash flow at the company is over $1.3 billion in the trailing twelve months, and the debt appears to be able to be covered at least on a current interest basis.

There is, as one might expect, a huge short position in DAL shares right now - some of that is no doubt due to merger arbitrage with NWA shares - but there is a 20 million share short position (about 7% of the float) in DAL right now. That is up from about 17 million shares short in April of 2008.

Technical Analysis

The above chart shows Delta Airlines stock for the last six months. The stock has been in a nose dive (gosh, these metaphors are easy in airline stocks) since stalling out in 2007. We see a little bit of stabilization at the $7 level, and at present we like what we see in the Relative Strenght [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines. Both lines are negative right now, but look like they are turning. We think the timing is right for a covered call on this name.

Investment Recommendation

We recommend that investors:

1) Buy DAL stock at present levels, roughly $7.60 per share, and;

2) Sell a December (Merry Christmas!) 2008 $10.00 call on DAL for $1.80 per contract. Current prices indicate that this will give investors a "static return", which assumes the stock is not called away but doesn't change much from $7.60 per share of 26% for the next 222 days until December's expiration.

If the stock is called away from you at $10 between now and December's expiration, investors will get to keep the premium on the calls (+$1.80) plus the sale price of $10 per share for Delta (a net gain of $2.40 per share), giving a return "if called away" of nearly 56%. Not too shabby for an early Christmas. If we see oil prices back off meaningfully during the summer or fall, these prices would materialize pretty quick, we think.

Investors will have just about seven months (until expiration in December 2008) to realize these levels if purchase of the stock and sale of the call occurs on Monday, May 12, 2008.

On a protective note, we would look to exit this long Delta stock / short call situation if DAL's share price broke down much below $5 per share. Call sellers would have some gain on the short calls, and we would remind you that you do need to buy back the short call if you sell the stock. This ‘trigger’ order can be entered with your broker.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in DAL stock or DAL options.