- The airline industry has been hard hit by the COVID-19 virus crisis with passenger revenue decimated for weeks.
- Delta spent more than a decade pursuing its goal of being viewed as a high-quality industrial company and will benefit from its transformation during its recovery.
- Delta's recovery plan compares very favorably to its largest competitors in multiple areas.
It is a surprise to no one that the airline industry became an early casualty of the COVID-19 virus crisis. The U.S. has become the world's most impacted country by COVID-19 as the virus was carried to the U.S. from China and western Europe. While transpacific traffic began to weaken as virus news in China grew more dire, the bottom fell out for U.S. airlines in March as the number of cases exploded in the United States and as travel restrictions from Europe and stay at home orders accelerated across the United States.
As some states begin the process of reopening their economies, a comprehensive fact-based and comparative analysis of the airline industry will help investors try to navigate the airline industry and the strength of Delta's recovery plan. Airline stocks are still highly volatile as investors have seen some days with strong gains punctuated by equally negative swings. Longer term, there are solid indications that the airline industry still has value; investors can register solid gains in certain airlines and especially Delta Air Lines (NYSE:DAL).
Parked Delta aircraft at Kansas City Source: JL Johnson
Corollaries, assumptions, and expectations
The U.S. airline industry today is largely the result of 40 years of domestic deregulation of the legacy segment (pre-1978 interstate carriers) that has been marked by consolidation over the past 10 years and chapter 11 reorganization post 9/11, the steady growth of a low cost segment, and the more recent rapid growth of ultra-low cost carriers. There are generally three carriers in each of the three categories with Frontier, an ultra-low-cost carrier, the only large U.S. airline that is not publicly traded.
During the past ten years, the U.S. airline industry benefited from the strong U.S. economy as well as industry capacity discipline and growing market segmentation, with certain carriers focusing on lower priced leisure markets while others have focused on higher value business travel and still others on the international marketplace.
Despite the distinct market segmentation, industry profitability and valuation has not been consistent across business types, indicating that carriers using all business models could be profitable. Delta, a legacy/global carrier and Southwest (LUV), the nation's largest low-cost carrier, led the industry in net income margins for 2019 and also were numbers 1 and 2 in market cap. Still, airline stocks as a group often move in the same direction and at very similar percentages on a short-term basis even though news might be released for a specific airline.
As the airline industry recovers from the coronavirus crisis, I believe that there will be greater differentiation of the financial results and valuations in the airline industry than was seen during the last ten years. A number of analysts believed that it would take a macroeconomic crisis in order to determine which carriers were capable of long-term survival. The coronavirus has become the catalyst that will determine whether U.S. airlines were prepared for a downturn and will also distinguish those that can deliver consistently solid financial results and valuations from those that cannot.
Delta was well-prepared for the coronavirus crisis
Delta spent the last ten years distinguishing itself from its legacy carrier peers. Up until the Great Recession, airlines had not ever covered their cost of capital and had accrued few if any cumulative profits. Most legacy airlines did not have investment-grade credit ratings due to their highly leveraged balance sheets.
Delta, and then-future merger partner, Northwest Airlines, entered chapter 11 bankruptcy on the same day in the same New York U.S. bankruptcy court in 2005. While their bankruptcy cases were separate and they emerged at different times, their merger announcement came a year after both emerged from chapter 11 - and just as the U.S. was heading into the Great Recession. While Delta laid the framework for transforming itself from the traditional legacy carrier business model before and during its bankruptcy, the Great Recession provided the opportunity for Delta to benefit from it and Northwest's trips through bankruptcy to not only quickly cut its losses in the post-Great Recession period but also to use the next decade to transform itself into the world's largest airline by revenue, market capitalization, and net profits, titles Delta held on December 31, 2019. For 2019, Delta's net income margin was virtually identical to Southwest, long considered the best-run airline business in the history of commercial aviation; Delta and Southwest sat financially at the top of the U.S. and global airline industry.
As the first quarter of 2020 unfolded, Delta relied on the strengths it built and reacted quickly and decisively to not only limit the financial damage to Delta from the virus crisis but also to strengthen Delta's position in the industry as the recovery phase begins. Now that all of the big four U.S. airlines (American (AAL), Delta, Southwest and United (UAL)) have reported their first quarter earnings and provide insight into their recovery plans and as the U.S. economy begins to reopen, it is clear that Delta's recovery plan is superior to its peers in building on the strengths that put Delta at the top of the industry.
Delta executives indicated that they understood early in the virus crisis that the keys to survival included being able to
1. gain sufficient liquidity to endure the reduced revenue that came from managing spread of the virus
2. adapt the business plan to the realities of the likely enduring unseen threat of the virus
3. match costs with the new level of revenues during the disease and economic recovery phases and
4. retiring the debt that Delta and other airlines would accumulate and return to the balance sheet strength to an investment-grade rating, which allowed the stock to compete with other high-quality companies.
Delta's strengths going into the crisis were substantial and will fuel its turnaround.
Source: Delta investor presentation, p. 5
While no one can accurately forecast airline industry revenue for the foreseeable future, there are encouraging signs that Delta and the industry might see demand recovery within the next few months. While TSA security checkpoint volume dropped to less than 5% of year over year levels, there have been recent, daily increases in the number of passengers traveling. Delta, like most airlines, has cut capacity through the month of May and for parts of June, but they are slowly restarting routes.
Delta's current network is operating at minimum levels of service in accordance with requirements under CARES funding assistance from the federal government. Unlike some of its competitors, on a pre-virus basis, Delta did not talk about or have strategies to deal with underperforming parts of its network. Domestically, Delta has hubs in every region of the United States except for Texas and over the past month has operated its network by serving smaller cities from the hubs closest to those cities. Delta's international network was uniquely and consistently profitable in every one of the three global regions (transatlantic, transpacific and Latin America). While government travel restrictions have necessitated suspending service to some markets, Delta has served key markets and partner hubs in Europe and Asia throughout the virus crisis. Unlike its legacy carrier peers, over the past decade, Delta supplemented its well-defined hub and spoke route system with focus cities throughout the U.S. where it generally relies on point to point (non-connecting) flights in cities with strong economic growth. I discussed Delta's focus city strategy in this Seeking Alpha article. Much of its focus city network has been temporarily dismantled based on low demand; the hub and spoke system is the most efficient means to serve a broad number of cities, esp. in a low demand environment. Delta was the largest airline in the U.S.'s top markets according to the latest DOT data for 2019 and also connects more passengers from small and medium markets to its global network; both of those characteristics of Delta's network will be key to its revenue recovery.
Delta's international partners were a strength going into the crisis but have been a point of criticism from some. Delta developed a series of partnership anchored by its equity investments in a half dozen partner airlines around the world; most of the equity is currently worth far less than DAL paid. Where permitted by law, all of Delta's equity investment airlines are also joint venture partners. Those partnerships will be increasingly important as Delta rebuilds its international route system. Unlike other airlines that also have antitrust immunized joint ventures, Delta's equity investments include a presence in the boardrooms of each of its equity partners, an advantage that will help Delta rebuild its network by strengthening not just its partner but also Delta's presence in the region which the partner serves.
Source for both: Delta 10-Q 1Q2020, p 14-15
Although passenger revenue has fallen to near zero, airlines including Delta are taking advantage of their widebody aircraft to operate cargo-only flights. Normally, about half of the world's air cargo moves in the bellies of passenger aircraft. Even with production facilities around the world slowed or stopped, air cargo rates have soared which, combined with low fuel prices, favors the operation of cargo-only flights. Delta has removed passenger seats from some aircraft in order to maximize cargo capacity and has also won FAA approval to use the overhead bin space of some of its aircraft for cargo. Cargo rates will likely remain high for the foreseeable future which will provide financial support for the re-initiation of passenger flights.
Delta's Technical Operations division will continue to be a source of revenue. Delta provides aircraft maintenance services to airlines around the world and is the largest contract maintenance provider in the Americas with margins that are believed to exceed that of air transportation services. While fleet strategies and the temporary grounding of significant portions of the global fleet will push back airline maintenance expenses, Delta has won contracts from two of the three global manufacturers to repair new generation aircraft engines.
Delta's biggest source of non-transportation revenue is from American Express; Delta is also Amex's largest partner. While credit card billings will be influenced by the return of business travel, Delta's partnership was on track to add up to $7 billion in revenue to Delta within the next couple of years, a distinctly higher amount of revenue than any other U.S. airline.
Of course, the biggest factor that will influence the return of revenue will be Delta's ability to convince passengers of the safety of air travel. Delta's CEO stated early during the crisis that a full return of travel would not be likely until a vaccine against the virus is in use. In the meantime, Delta and other airlines have implemented enhanced aircraft cleaning processes and procedures to provide social distancing on its aircraft. Enhanced sanitation and virus safety procedures mirror the anti-terrorism procedures that have become commonplace over the past fifty years. The origin of airport security checkpoints can be traced in part to frequent hijackings of commercial aircraft to Cuba; those same security checkpoints and procedures were enhanced in the wake of 9/11 as airlines attempted to convince passengers that air travel was again safe. Of course, there is a great deal of collaboration with governments behind the scenes and that will be true regarding transmission of the virus. While Delta says it is not certain how far air travel safety in a post-virus world will go, efforts at cleaning and social distancing will likely be far more important until medical advances limit the presence and impact of the virus.
Finally, demand return will be closely tied to a new sense of the necessity of air travel in a world where telecommunications have advanced far beyond what existed in any previous external shock to the air transportation system. While Delta and other airline executives accurately note that humans have deep social needs to be present with each other in order to transact some of the most significant parts of life and business, technology and the ability to work remotely has allowed business to continue during the lockdown in a potential reshaping of business travel that will negatively impact the return of airline revenues. Given that Delta's business model pre-virus was built around successfully providing high-quality air service and attracting premium revenues, adapting to the new realities of commercial aviation, whatever that might be, will require Delta to match revenues with costs.
Cost Control and Cash Management
Cost control and cash management have long been key to Delta's strengths in the global airline industry. In the absence of certainty about the timing and degree of revenue recovery, cost control plays an even larger role than ever. Delta's cost control in this crisis focuses on several areas and each is unique among the U.S. airline industry; its CEO said they intend to use this crisis to reimagine every aspect of the business and engineer costs out of their system as they rebuild the airline.
Notably, Delta said that it is working to make 60% of its costs as variable costs, an unusually high number for an airline. No other airline has indicated that it can convert as many of its costs to variable costs. Delta also said that it will be able to cut 50% of its costs for the 2nd quarter.
Delta was criticized over the past several years for its older fleet, although, in reality, United had the oldest fleet among the big 4 as of December 2019. Delta's fleet strategy has been built around the cyclical nature of the industry and ensures that it has adequate unencumbered aircraft it can retire in downturns with minimal costs and write-downs. The following chart shows Delta's fleet as of March 31, 2020, showing the average age of each fleet type as well as its ownership or lease status.
Delta fleet as of 3/31/2020 Source: DAL 10-Q, 1Q2020, p. 33
Delta has older as well as newer aircraft of various sizes across its domestic and international fleets so that it has multiple options to retire aircraft as it becomes necessary to do so. Delta said it would be closely looking at every fleet type that it had previously considered for retirement in the next five years; it has already announced its intention to ground the remainder of its MD80 and MD90s by this summer.
One of the challenges of fleet management with large, complex fleets is that pilot staffing is impacted by the removal or addition of fleet types as pilots are forced to change the aircraft and position they fly, potentially costing hundreds of millions of dollars in retraining expenses.
Delta's labor cost reduction efforts appear to be the most significant of the big 4. Early in the crisis, Delta offered unpaid leaves to its ground employees and flight attendants, all of which are non-union. Delta has stated that more than 35,000 employees, nearly 40% of its workforce, have agreed to take unpaid leaves of absence of one month or longer. Other airlines initially offered partially paid leaves of absence to their unionized ground staff and flight attendants with some unpaid leaves offered later - but many of the other airlines will not be able to get their employee costs down as much or for as long given that many of their employees are on partially paid leaves of absence. Some airlines have already offered early retirement programs but Delta so far has not.
Prior to accepting federal grant money, Delta also reduced the hours of most of its remaining ground employees in order to more closely match the number of working employees with travel demand. Several smaller airlines have also used this practice while United did the same thing after accepted federal grant money, invoking complaints from some legislators even though the CARES act does permit the reduction of hours but not base pay.
Reducing pilot compensation at each airline is more complicated than for most ground employees. While Delta encouraged many of its non-union employees to take leaves of absence and apply for state and later federal unemployment before the CARES act was passed, that strategy does not work for pilots since they cannot replace much of their income via unemployment. Pilots including at Delta, are discussing strategies to reduce pilot costs commensurate with reductions for non-pilot personnel with Delta and many other airline pilot unions agreeing to reduce the number of flight hours used to calculate minimum monthly pay.
Delta is also reducing its labor costs through elimination of profit sharing. Its employees just received checks representing, on average, 16% of their salaries, making Delta's profit-sharing program in 2019 the richest not just in Delta's history but also, in total, for all of corporate America. It is not likely that Delta or any airline will accrue profit sharing in 2020.
The Coronavirus Aid, Relief, and Economic Security (Cares) Act included $25 billion for U.S. passenger airlines with the first part of the act providing immediate cash to protect airline employee salaries, partially via direct grants and partially via loans to each airline. Delta received $3.8 billion in grants and $1.6 billion in an unsecured 10-year low interest loan. For the loan portion, Delta issued to the U.S. Treasury 6.5 million warrants to acquire Delta common stock with an exercise price of $24.39 per share over the next five years, representing an approximately 1% dilution of DAL stock. Delta is eligible for $4.6 billion in loans via the second part of the CARES act; Delta has said it will apply for the loan but will not have to decide whether to take the funds until September 30, 2020. Most other U.S. airlines have accepted federal assistance under part 1 and plan to apply for loans under part 2, but like Delta might not accept the loans. The CARES Act also allows airlines to defer employer social security contributions to increase cash flow; Delta values this benefit at $200 million for 2020.
The CARES Act was intended to prevent widescale bankruptcies in the airline industry and to provide short-term liquidity to cover employee costs. The roughly six months between the approval of the CARES Act and the expiration of its employee protection and minimum service requirements allows airlines, including Delta, to develop viable business plans for the virus recovery period. The viability of those business plans will certainly be scrutinized when and if airlines choose to accept loans from the federal government, if they are approved. The necessity to be able to match costs to revenues and service the debt - much of which will be due in the next five years - will be the tipping point between success and failure for some airlines, and the answer will not be the same for each airline. Delta will be on the side of a successful restructuring.
The CARES Act has actually resulted in a willingness by private lenders to make collateralized loans to airlines. Delta started the coronavirus with an investment-grade credit rating; it believed it did not need to maintain cash balances as large as its peers because it could access capital markets if necessary. Delta has accessed more than $7 billion in debt, larger than any other US airline. DAL began the virus crisis with $20 billion in unencumbered assets excluding its loyalty program and appears to still have half of that amount available to it. Several U.S. airlines have issued equity in the past month but DAL has not.
Cash burn has been a heavily focused statistic for airlines but several words of caution are in order. First, cash burn includes cash refunds and, despite DOT reminders that U.S. airlines must provide cash for cancelled flights if asked, there are a number of customers that are accepting - perhaps with incentives from the airlines - to accept credit vouchers over cash. In March, refund activity constituted up to 20% of its cash burn. Delta, like United, has large international route systems that generally book much further in advance than domestic flights, meaning that the cash refund rate for those two airlines will be higher than largely domestic airlines. Cash burn also includes revenue projections and those numbers are changing constantly; because DAL reported its financial results and provided guidance a week or more before its competitor airlines, Delta's numbers might not be directly comparable given the rapidly changing financial situation for airlines. Delta's most recent estimates are for cash burn of up to $50 million/day in the 2nd quarter which will include very low demand for the months of April and May.
During the past three years, Delta committed to massive fleet and airport spending using its then-industry leading levels of cash flow. Delta committed to replacement of over 200 aircraft over three years; Delta completed a large order for 737s from Boeing so all of its current order book is for Airbus aircraft including the A220 which Delta ordered as the Bombardier C Series. Delta has not reached an agreement with Airbus on restructuring its order book but did say that it will not take delivery of any further new aircraft in 2020 unless they are already financed.
Delta also is self-financing a number of airport improvement projects including a multi-billion rebuild of its terminals at NYC LaGuardia and Los Angeles International Airport. Interestingly, Delta said it may accelerate some of its airport projects to take advantage of lower flight levels to minimize the cost of rebuilding around flight operations.
As of March 31, 2020, Delta had an unfunded pension liability of $8.5 billion which reflects most of the former Delta and Northwest pension plans; Delta had accelerated voluntary funding of its pension plans over the past three years and now does not expect to have to make any contributions to its pension plans in 2020.
Delta had also been reducing its NOLs over the past five years and expected to become a cash taxpayer later in 2020. DAL and the entire U.S. airline industry will accumulate NOLs that will eliminate cash payment of income taxes for years, further reducing DAL's cash requirements
From a financial strength standpoint, Delta entered the virus crisis stronger than its most direct peers American and United and DAL has demonstrated that its incoming financial strength has paid dividends in the earliest days of the virus crisis. Even though all airlines have taken on additional debt in order to fund operations, DAL's leverage ratio remains about one-half of UAL's which itself is about one-half of AAL's.
DAL 10-year chart Source: Seeking Alpha May 4, 2020
One of the most significant factors that favors a stronger recovery for Delta than its peers is the competitive environment in the airline industry, not just in the U.S but also globally.
First, some are quick to point out that the big 3 - American, Delta and United - are currently saddled by their international route networks which will take longer to recover than the domestic market, in part since the peak international travel should be starting right now but will be missed. However, American, Delta and United compete in the U.S. domestic market alongside the international market. During the next few months as the industry works its way through recovery, every U.S. airline will be aggressively competing for every passenger that they can carry in the domestic market using every pricing and product strategy that they use. As a full service, global carrier that competes against low-cost and ultra-low-cost carrier prices and products, Delta is as well-positioned as American and United. However, Delta also has the highest market share in its hub markets and had a revenue premium across its network prior to the virus crisis that will certainly allow it regain pricing strength in its markets before its peers.
Secondly, it is a given that there will be airlines that will not survive this crisis. While the U.S. government has committed to providing more than half of the aid and liquidity to its airlines compared to airlines around the world so far, U.S. airlines ended 2019 as the most profitable in the world and Delta was the most profitable airline in the world. Other airlines, especially in the international market, will not survive. Others are or will enter whatever form of restructuring is available in their home countries, some of which will succeed while others will fail.
I wrote years ago on Seeking Alpha Identifying The Winners In The Low Fare Transatlantic Air Fare Battle that a growing long-haul low-cost airline movement was beginning across the Atlantic; even before the virus crisis, a number of European low-cost carriers failed and even more are fighting for their survival including Norwegian, which became the largest transatlantic low-cost carrier. Delta, as the largest carrier across the Atlantic in 2019, will certainly benefit from the reduction in capacity from low cost carriers and from stronger pricing as the market recovers.
Finally, Delta's history shows that it has grown more in competitive markets than any of the big four U.S. airlines over the past 40 years and that will likely be the case with this recovery. Delta entered domestic deregulation over 40 years ago as the sixth-largest U.S. airline but became the largest U.S. airline by revenue in 2019 in part as a result of growth in the largest U.S. markets including New York, Boston, Seattle and Los Angeles. While it is not clear how Delta will reduce its domestic capacity, both American and United had implemented strategies to improve their performance in a number of their key hubs which they will have to pull back, likely resulting in opportunities for Delta to grow.
Delta is now the second-largest U.S. international airline behind United; however, United's international margins have been lower than Delta's, making it likely that United will reduce a greater proportion of its international network than Delta. United just recently notified its pilots that it will displace up to 5000 of them from higher to lower paying categories, likely a result of a significantly smaller international network. Delta's joint venture plans with Latam are certain to move forward, increasing Delta's size in Latin America, the only region where American is the largest U.S. carrier.
Finally, Delta has overcome industry adversity before, not only increasing margins at a faster pace than any other airline but also reducing debt; all airlines will spend years retiring debt they are taking on to survive this year and yet DAL has the best track record for retiring debt. As of March 31, 2020, Delta still has the highest stockholders' equity in the industry, more than 50% higher than LUV and UAL.
These charts illustrate the progress Delta made towards its goal of being viewed as a high quality industrial company in the most recent 5 years compared to the 5 years after it merged with Northwest Airlines.
Source for both: DAL 10-K 2019, p. 27
Source for both: DAL 10-K 2013, p 25,26
I have long stated on Seeking Alpha that airlines should be held long-term rather than used as trading stocks but that there is a distinct difference in financial and valuation performance between U.S. airlines. DAL's track record of success during and after major industry crises will guide its recovery from this latest crisis. On multiple levels, Delta has the strongest airline recovery plan from the COVID-19 crisis.
I believe DAL has an 18-month price target of $40.
This article was written by
Analyst’s Disclosure: I am/we are long DAL. 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.
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