Airlines are a notoriously difficult business. From fuel costs to the capital intensity needed to run an airline, this industry is certainly a difficult one, unless you are Southwest (LUV), which is the only airline to have never filed for bankruptcy. But despite the difficulties of the airline industry, not every company needs to be avoided. One airline in particular has an intense focus on reducing debt and controlling costs, and by doing so, it is setting the stage for a rally in its shares. And that airline is Delta (DAL).
Delta, like all airlines, is exposed to issues beyond its control, namely fuel costs. But Delta is the only airline that is doing everything it can to lower those costs, including buying the Trainer refinery in Pennsylvania to save $300 million in annual fuel costs (more on that later). We believe that Delta's focus on strengthening its financial profile by aggressively paying down debt and lowering its fuel costs will lead to a rally in the stock, and we will detail our thesis in this article. We will be focusing on 5 key themes: an overview of Delta's Q2 2012 results, its hedging practices, the Trainer refinery purchase, Delta's finances, and the impact of the bankruptcy of American Airlines. For the record, unless otherwise noted, financial figures and management commentary will come from one of 3 places: Delta's Q2 conference call, its Q2 2012 10-Q filing, or its latest earnings release.
Delta reported its Q2 results on July 25. Delta posted a GAAP loss of $168 million ($0.20 per share) on revenues of $9.732 billion. Delta's non-GAAP income came in at $586 million, or $0.69 per share. That topped non-GAAP estimates of $0.68 per share. The difference between GAAP and non-GAAP results was due primarily to hedging losses, which we will explore in greater detail in the next segment of our article. CEO Richard Anderson sounded upbeat on the company's conference call, noting that Delta has produced a unit revenue premium compared to the overall industry for the past 15 months, and that he expects that to remain the case. The company's 9.1% operating margin rose by 2% from Q2 2011, and Delta forecast that its operating margin will rise sequentially to 10-12% in Q3.
Delta has been aggressive in getting its ducks in a row. The company has signed a new pilot contract that lasts through 2015, giving the company a great measure of certainty for several years. Included in that contract is a clause that allows Delta to modify its regional fleet, replacing more than 200 50-seat aircraft with Boeing 717's that will be leased from Southwest. Delta will save hundreds of millions in maintenance costs. Delta's pilots will also get raises, with a 13% increase in pay slated for 2013 and 3% increases for both 2014 and 2015. Happier pilots are more productive pilots, and more productive pilots will lead to higher profits for Delta (that is true in all industries; employees are more productive when they enjoy their work environment, which in turn, leads to higher profits). Delta has also finished its LaGuardia expansion, the largest expansion there in 40 years, and has finished its JFK expansion as well.
So far in 2012, Delta's stock has outperformed the S&P 500, and nearly every other airline. The only airlines to best Delta in this regard are Spirit Airlines (SAVE) and US Airways (LCC), which has seen its shares nearly double on anticipation of a buyout of American Airlines (more detail on that later).
However, Delta's shares have pulled back over the past month, falling over 15%. We believe that this pullback does not reflect the company's fundamentals. Delta's CFO, Paul Jacobson, seems to agree with this view. On August 7, he stepped into the market and bought 50,000 shares of Delta at an average price of $9.342. If the CFO of the company is willing to invest $467,100 in it, we believe that investors should be willing as well.
To Hedge or not to Hedge? That is the Question
Questions about whether or not airlines should hedge their fuel costs have existed ever since they began doing so, as a way to control their biggest and most variable expense. Hedging is an art, not a science, for it is impossible to ever accurately predict what is going to happen to fuel costs. For those unfamiliar with how airlines hedge their fuel costs, we will provide a quick overview. Airlines use swaps to lock in their fuel costs for a predetermined period of time. Those swaps allow an airline to budget with some certainty, and it allows refiners to lock in their margins (known in industry terms as the crack spread). These swaps require a counterparty, which is usually a financial institution or major oil company, and they rise and fall in value with the price of jet fuel. For example, an airline may hedge 30% of its fuel costs for the next year at a price of $3 per gallon. The airline purchases swaps to lock in 50,000 gallons of jet fuel at $3 per gallon. However, therein lies the double-edged sword. That airline's swap moves with the price of jet fuel. If the price moves up to $3.10 per gallon, the airline must pay that much to buy its fuel, but is owed $5,000 from its counterparty, negating the extra 10 cents in cost. But if jet fuel prices fall to $2.90, the airline owes $5,000 to its counterparty, negating the extra 10 cents in savings.
Delta's GAAP loss in Q2 was driven by mark-to-market adjustments on its fuel hedges. Delta's hedges (those that settle in future quarters) cost the carrier $561 million in Q2. As jet fuel costs slid in the second quarter, Delta found itself paying more than the spot-market rate for fuel because of its hedges. Hedges allow airlines to protect themselves from price shocks, but do not allow them to profit in a meaningful way should fuel costs drop. On the company's conference call, CFO Paul Jacobson reiterated the company's commitment to hedging, stating that, "We entered the June quarter with a hedge book that was structured to protect against increases in oil prices up to $150 a barrel. We remain committed to our hedging strategy and we view our hedge portfolio as protection from volatility in the fuel markets. We don't expect our hedge book to be a profit center but as a means to better manage our business by reducing the volatility of our largest expense." The problem with fuel hedges is that airlines have to forecast volatility in addition to actual prices. If fuel costs drop too far, airlines will be sitting on losses because they overpaid for fuel.
Some airlines, such as US Airways, don't hedge their fuel costs at all. US Airways CFO Derek Kerr has repeatedly stated that his company sees hedging as being far too expensive relative to the benefits it provides. US Airways takes its chances on the spot market. However, like hedging, that comes with its own set of risks. US Airways may benefit when fuel costs are low, but its refusal to hedge exposes it to price shocks that could cost the company a great deal if oil prices spike. Ultimately, we do not feel that investors should choose which airline, if any, to invest in based on whether or not they hedge their fuel costs. There are benefits and risks with both hedging and not hedging, and each airline chooses what suits it best. For Delta, hedging provides certainty as to what its costs will be, and that outweighs the mark-to-market losses it needs to account for on a GAAP basis.
The Trainer Refinery: A New Cost Reducer
Delta's move to buy the Trainer refinery in Pennsylvania created a lot of waves in the airline industry when it was announced. Delta's Q2 cash flow statements included $180 million in costs for the Trainer acquisition. The refinery will begin operations in either September or October CFO Paul Jacobson said that the refinery will post a small loss in the September quarter, but begin to reduce Delta's fuel expenses in the December quarter. Delta reiterated its estimate of $300 million in annual fuel cost savings once the refinery is up and running. Analysts quizzed management on how those savings will be realized, and CFO Paul Jacobson stated on the call that, "the $300 million in savings comes from the sale of the products in excess of the cost of manufacturing and cracking crude oil against the index prices that we've seen. And while there's been volatility in the crude oil markets, crack spreads have actually expanded slightly during that time period and we don't anticipate any change from our original guidance." Delta's President, Ed Bastian, also jumped in at that point on the call, noting that Delta backtested its purchase of the Trainer refinery using data from the past 6 years, and that its models produced annual cost savings of between $300 and $500 million. We are confident that Delta's move to purchase the Trainer refinery will be a long-term positive for the company, and expect more color to be provided when the company reports its next quarterly results in October.
Delta's Financials: Laser-Like Focus on Costs and Debt
Delta is working extremely hard to control its costs and reduce its debt burden, which form the core of our bullish thesis. Delta has bought the Trainer refinery, which will save $300 million a year in fuel costs (Delta spent $3.305 billion on fuel in its latest quarter). Delta's partial phasing out of its regional jets will save it "substantial" amounts in maintenance expenses. While Delta declined to publicly disclose the precise number, Delta's pilots' union estimated the savings at $473 million. Furthermore, Delta is set to reduce its headcount by 2,000 in 2012 via early retirement, and the company is not planning on replacing those employees, which will result in improved productivity. Delta's focus on costs is already bearing fruit. The company forecast that its operating margin will rise to 10-12% in the next quarter.
Delta's biggest focus, however, is on reducing its debt burden. Delta ended 2009 with $17 billion in debt, a figure that has fallen to $12.1 billion as of June 30, 2012. Delta paid down $374 million of debt and is on track to meet its target of $10 billion in net debt in 2013. Delta's moves to pay down debt benefit the company enormously. Deleveraging gives the markets increased confidence. As CEO Richard Anderson stated on the call, "we think the most important thing we can do for our shareowners is de-risk and de-lever the business." As an airline, Delta needs to prove to the markets that it can be sustainably profitable, and deleveraging is a prime way to do so. Already, Delta's moves are paying off. S&P revised its outlook on Delta to positive from stable in May, citing the company's free cash flow and the potential for debt repayment to accelerate beyond what S&P is currently assuming (for the record, Delta has a B rating from S&P at the present moment). Furthermore, debt reductions help reduce Delta's interest expense. Delta paid $207 million in interest this quarter, down 11.16% from the $233 million it paid in the prior year quarter. On the conference call, analysts asked what Delta plans to do once it hits its $10 billion net debt target. The key question came from JPMorgan, which asked, "Once you get below the $10 billion net debt target, what's next...I think the concern out there is that you're tempted to fall off the wagon and you go on some sort of a growth bender. That's not particularly my concern, but I hear it from investors all the time. On the other hand, there are pension issues that still need to be addressed. There's possible restoration of dividends, share buyback potential. I mean sort of take your pick and don't limit it to those." The fact that buybacks and dividends were even brought up shows how far Delta has come. Airlines don't pay dividends, and they don't buy back stock. Southwest is an exception, but its 1 cent per share quarterly dividend (for a yield of 0.44%) isn't exactly a shining example of the industry's return of capital to its investors. CEO Richard Anderson responded that, "I think we have demonstrated now for a number of years in a row a unique discipline around how we deploy our capital...we think the most important thing we can do for our shareowners is de-risk and de-lever the business. So we have some time to make that decision because we're scheduled to hit our net debt at $10 billion at the end of 2013. I think you can reasonably expect that no matter what we do, we're going to continue to grind down that net debt number, because that both improves our EPS quickly because it comes right out of non-op which benefits our shareholders significantly. So I think no matter what, there are two principles and we have some time to discuss this with our investor base...our ultimate goal, it's going to take us a while, is to get back to investment grade." While CEO Richard Anderson declined to provide a timetable for getting back to investment grade, he made it clear that this is Delta's goal, and that he views deleveraging as an essential component of his tenure as CEO. We fully agree. As an airline, the onus is on Delta to show that it is financially sound. The company has been paying down debt aggressively, and we see nothing to suggest that the company's focus will shy away from that.
Delta's balance sheet and liquidity profile remain strong. Delta ended this quarter with $3.498 billion in cash & investments, and has $1.8 billion in revolving credit lines, which currently remain undrawn. The company posted solid cash flows this quarter of $683 million, which includes funding of its pension plan. As of June 30, 2012, Delta has completed its pension funding requirements for the year. Delta also posted free cash flow of $31 million in Q2 (defined as operating cash flow less capital expenditures), and we expect the company to further improve its cash flow as cost cuts that the company has implemented begin to flow through the income and cash flow statements.
American Airlines: A Deal With Something for Everyone
As American Airlines works its way through the bankruptcy process, speculation has swirled about the airline's fate. Will it remain independent? Will it be bought out? Conventional wisdom suggests that US Airways will buy American Airlines out of bankruptcy. After all, US Airways has made no secret of its desire to buy American, and the benefits are clear. US Airways would gain a role in one of the 3 leading airline alliances, as well as meaningful international exposure, putting it in a much better position to compete with both Delta and United (UAL). For Delta (as well as United), taking over American yields a different set of benefits. Both carriers are the flagships in their respective alliances (SkyTeam and Star Alliance), and both have international routes. A US Airways/American merger has obvious benefits, while a Delta/American merger comes with its own sets of issues and benefits, which we will discuss a bit later.
Investors should not look at a combined US Airways/American Airlines as a negative for Delta. Frankly, Delta will be fine no matter what happens. If American emerges from bankruptcy as an independent carrier, the industry's dynamics will remain essentially the same. And if US Airways does merge with America, Delta will benefit. Analysts pressed the company about this on its conference call. Morgan Stanley analyst John Godyn was blunt, asking, "when investors think of Delta, I think increasingly they look at you as aggressive and creative at trying to better manage or control some of the forces that other airlines leave to chance and maybe best symbolized by the recent refinery deal, and that's something you touched on in your prepared remarks. But as we think about scenarios surrounding American's emergence and the possibility of M&A, is this a situation where you think the outcomes are out of your control or does Delta have the ability to drive the situation toward outcomes it favors?" The essence of his question was whether or not Delta will bid for American. CEO Richard Anderson of course declined to provide an answer, but he did say that, "overall, one, at Delta we will continue to always control our destiny. And by pushing a lot of different opportunities and leverage across the business and, number two, global consolidation is good for the business model." At a minimum, Delta has looked at a bid for American. Sources close to Delta have told the Wall Street Journal that in January, Delta hired Blackstone to help it study whether or not to bid for American. American Airlines has until December 28 to file its own reorganization plan with the U.S. Bankruptcy Court. After that, third parties may step in with their own plans. Whether or not Delta will bid for American will become clearer towards the end of 2012. Sources close to Delta have said that the carrier has conducted an anti-trust analysis and found that with some concessions, the deal could pass an anti-trust review. If Delta were to merge with American, the deal would yield benefits, but would also create issues. American would cement Delta's grip on JFK and the rest of the New York market, strengthen the carrier's Latin American business, and turn Delta into the undisputed leader of the trans-Atlantic market (and boost its presence in the trans-Pacific market). But, Delta would have to deal with American's unions. The majority of Delta's overall workforce (not just its pilots) are not unionized, while American's workforce is highly unionized (one of the reasons why US Airways has been so aggressive in courting their support). Buying American will also catapult Delta back into the #1 slot in terms of airline size by traffic.
However, Delta will still benefit even if it does not end up buying American and US Airways does. Consolidation is indeed good for the industry. Nothing that we write in the article can mask the fact that the airline industry is a commodity industry. At the end of the day, what an airline is selling you is a seat on a plane from Point A to Point B. The differentials are price and service. Consolidation will most likely result in higher prices across the industry, which will benefit every airline, including Delta, because the removal of another airline from the market will give the remaining airlines better pricing power, which will flow through to Delta's bottom line.
Delta's valuation is unassuming, and we believe that its multiple may rise as investors gain more confidence in the sustainability of Delta's finances as it continues to cut costs and reduce debt. Delta trades at just 4.11x its estimated 2012 earnings estimates, and 3.21x its 2013 estimates (data is from Reuters).
(click to enlarge)Delta is set to grow its EPS by 27.93% in 2013, even though revenues are projected to rise just 2.19% in 2013. This discrepancy serves as proof of the effects of Delta's cost cutting and debt reduction, which is leading to increases in Delta's margins.
The airline industry of today is nothing like it was only 10 years ago. Airlines have made dramatic improvements in controlling both cost and capacity, and profits have returned. We think that Delta's best days are ahead of it, and that the time to buy is at hand. Delta is focused on reducing its costs and debt, and those initiatives are already paying off. Delta should not see any negative effects from a resolution of American Airlines' bankruptcy, no matter what it may be. In our view, Delta is setting the stage for a rally, and we think that, in time, investors who add to or initiate positions in the company will be rewarded for their conviction.