The airline industry is in a new era, but the biggest risk remains one from the old era. The industry is better focused on profitable capacity growth and passing along fuel costs and savings to customers, but the unions increasingly want a bigger share of the profits.
In the case of Delta Air Lines (NYSE:DAL), the top operated legacy airline remains in heated negotiations with the key pilots' union. My investment thesis is extremely bullish on the airlines with one big potential hiccup. The big concern is whether the unions, and especially the pilots, will derail the bullish trend.
When last bringing up the risk of the unions derailing my bullish investment story on Delta Air Lines, the comments section got very heated. The key though is that one can argue either way on whether the pilots deserve a big raise, but an investor needs to consider the opposite direction of the unions.
At the time back in January, the pilots had rejected a proposed 22% pay raise over three years for a requested 40% pay increase compounded over three years. The numbers aren't exactly apples to apples with some profit sharing concessions and changes in time rules thrown into the mix. The latest news is that the Air Line Pilots Association International (ALPA) filed for federal mediation after failing to come to an agreement on a contract.
Regardless of the outcome, the news again places the airlines in a position of inability to control employee wage costs. With lower oil prices, salaries and wages are the biggest cost now, by far. For 2015, the mainline wages and profit sharing were over $10 billion for somewhere around 30% of mainline operating revenues while fuel costs were roughly 19% of the same revenues.
Source: Delta Air Lines Q415 earnings release
According to some numbers from Airways News earlier this year, the Delta pilots are deserving a raise to bring their total compensation in line with the recent raises for the pilots of the other legacy airlines of American Airlines Group (NASDAQ:AAL) and United Airlines (NYSE:UAL). The issue though is whether a group being paid in the top 5% of U.S. household income levels deserves a big pay raise because the amount equates to the pre-financial crisis levels.
Based on the peak compensation years of 2003 and 2004, the 2015 dollars are equal to $365,000 and $383,000. According to the report, pilots had total compensation of $262,000 last year leaving them over 30% below the peak levels adjusted for inflation.
The problem with providing pilots with a 40% raise is that the group only makes up roughly one-third of the labor costs for the company that spent $8.8 billion on salaries and $1.5 billion on profit sharing last year. Anybody doing a quick calculation will see a huge hit to the airlines if the company suddenly paid a 40% raise to all employees. Vinay estimates that the pilots increased annual cost alone would reach $750 million by 2018.
Will The Solid Value Proposition Last?
One can quickly see how the forecasted operating profit of over $5 billion quickly disappears if total labor costs rose by 40%. Clearly, analysts should already have a 20% increase for the pilots factored into the 2016 EPS estimates of $6.72, but the numbers will take a hit if this is only a tipping point on labor costs.
My fear doesn't exist with higher fuel costs as the airline industry will raise fares on those higher costs. The big issue is labor costs shifting towards fixed costs of salaries and out of the flexible profit sharing category. Or more importantly, an increase in the fixed costs without a drop in the flexible cost amounts.
Assuming the substantially higher labor costs doesn't happen, Delta Air Lines is a phenomenally cheap stock. Other industrials like FedEx (NYSE:FDX) and Norfolk Southern (NYSE:NSC) routinely trade at P/E ratios requiring a 50% rise in Delta to match.
DAL PE Ratio (Forward 1y) data by YCharts
According to other EPS estimates, Delta Air Lines only trades at roughly 6.6x 2017 EPS estimates requiring a double in the stock to match the multiples of FedEx and Norfolk Southern.
This article isn't really to discuss whether the pilots deserve a pay raise, but how to handle an investment based on the outcome. The biggest fear for shareholders is that unions, including the pilots, are able to demand big wage hikes based in part on lower fuel prices to only have Delta eventually face an environment of higher wage and fuel costs.
At the current valuation, the stock can survive and thrive a more muted pay raise for the pilots. Investors, though, should panic out of the stock if the signs start existing that all unions are going to garner much higher pay rates in the near future.
Disclosure: I am/we are long AAL.
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: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.