Delta Air Lines To Soar Higher

Summary

• Delta Air Lines delivered 2.5% PRASM growth in June along with substantial decline in fuel costs year over year.
• It is expected to deliver 2.5% PRASM growth for Q2 which would be the first quarter of unit revenue growth since 2014.
• It should be able to deliver adjusted operating margin of 18% to 19%, which would be the highest among legacy carriers.
• Delta Air Lines has seen lowest gains among legacy carriers in the last one year; stronger results in this quarter should make it a more attractive choice for investors.

Delta Air Lines (NYSE:NYSE:DAL) has been one of the laggards in the airline industry in the past one year. While other airlines showed unit revenue growth, DAL has shown decline in this important metric. But better Q2 numbers and future prospects can make this the next big winner within the airline industry.

A turnaround in passenger revenue per available seat mile (PRASM) started in April when it showed 1% growth. In May, DAL’s PRASM increased by 3.5% and in June it reported a 2.5% gain. At the same time, it expects the fuel costs to decline to $1.68-1.73/gallon in Q2 compared to $1.97/gallon a year ago.

Increase in unit revenue and a decline in fuel costs should allow margin expansion. It is expected to deliver adjusted operating margin of 18% to 19% in this quarter. It should be able to deliver good PRASM growth in July and August as it will see easier comparison from last year. In the last one year DAL has seen lowest stock growth among legacy carriers. It grew by 45% compared to 71% by American Airlines (NASDAQ:AAL) and 85% by United Continental (NYSE:UAL).

Good Performance

DAL is set to deliver unit revenue growth after showing a decline for over 2 years. While other airlines were able to move to a growth path, DAL continued to deliver unit revenue decline until the first quarter of 2017. In April, it finally showed PRASM growth of 1% which increased to 3.5% in May and 2.5% in June. For the second quarter it is expecting 2.5% PRASM growth.

A decline in fuel costs is also going to provide a boost to earnings. Last year DAL had to incur some major losses as it closed its fuel hedging positions. DAL's management is expecting fuel costs to be in $1.68-1.73/gallon range, down considerably from $1.97/gallon it paid in Q2 2016. The non-fuel costs have increased at a faster pace of 4% in the first half of 2017. Non-fuel cost growth is expected to decline to 2% in the second half of 2017.

Good unit revenue growth and lower costs should help in margin expansion. DAL is expecting adjusted operating margin of 18% to 19% and pre-tax margin of 17% to 18%. In comparison, AAL is expected to deliver pre-tax margin of 13-14% whereas UAL is forecasted to show even lower margin of 10-12%.

Future prospects and valuation

DAL should continue to deliver better unit revenue numbers in the next two quarters as it would have to compete with easier comparisons of last year. In July 2016, DAL’s unit revenue declined by 7% YOY and in August 2016 it saw an even bigger decline of 9.5%. Fuel costs should also decline and non-fuel costs should stabilize at a lower growth rate as maintenance costs are curbed.

DAL is looking to replace a major part of its fleet with newer, more efficient 737-900ERs and A321s. Fleet modernization should help in reducing the unit costs growth over the next few years.

Fig: Comparison of forward PE, operating margin and dividend yield of DAL, AAL and UAL

In the past few quarters, both UAL and AAL have shown much higher gains in their stock which has pushed their forward PE to the same level as DAL. At the same time, DAL has much higher margin and yield than other two legacy carriers. It has the additional benefit of lower comparisons and margin expansion possibility in the next few quarters. This should help DAL perform at a much higher level than other competitors.

Investor Takeaway

Delta Air Lines will be delivering unit revenue growth in Q2 after a long gap. It is also seeing decline in fuel costs which will help in expanding the margin. The non-fuel costs are expected to grow at a lower rate in the second half of the year. Fleet modernization should deliver better productivity and lower growth of unit cost.

Among the legacy carriers, DAL is ideally placed to deliver better results. It is trading at similar valuation levels compared to AAL and UAL while also giving a good yield of 1.49%. This should help in improving bullish sentiment towards the stock, making it a good bet at the current price.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.