Delta Is On Sale Now; Better Business Post-COVID

Summary

• Delta is trading at a 65% discount to $78 TP with 188% upside.
• US full service carriers are best positioned in the global value chain.
• Delta is best-in-class and COVID accelerates self-help opportunities.

Company Overview

Delta Air Lines, Inc. engages in the provision of scheduled air transportation for passengers and cargo. It operates through the Airline and Refinery segments. The Airline segment provides scheduled air transportation for passengers and cargo. The Refinery segment consists of jet fuel and non-jet fuel products. The company was founded by Collett Everman Woolman in 1928 and is headquartered in Atlanta, GA.

Investment Thesis

Delta is trading at a 65% discount to TP (188% upside): Delta’s stock is on sale by any metric:

• 1.21x P/B vs. 2.4x P/B Dec. 2019 (up from low of 0.86x in March)
• 5 Yr Forward P/E of 3.9x vs 9.4x 5 yr avg P/E
• Delta’s credit card program w/ AMEX is valued at $38B, 2.2x Delta’s current market cap

At first, Delta’s depressed valuation was justified. The travel ban created liquidity issues and raised questions about the company’s ability to continue as a going concern. But with the CARES Act bailout for airlines passed, capital markets reopening, and travel slowly resuming (especially internationally where countries are a few months/weeks ahead on the infection curve), the company’s existential issues are behind it now. If Delta needs additional liquidity it has a significant number of unencumbered assets it can tap for financing, as well as its $38B credit card program with AMEX (United has already tapped its credit card program without giving up control).

Yet, Delta’s valuation remains depressed. Investors still have concerns over the pace of reopenings in the US, development of a vaccine, and the resumption of travel, and are penalizing Delta with a steep discount. Assuming Delta’s earnings eventually return to pre-COVID levels (I use pre-COVID 2020 estimates in my valuation), the stock is currently trading at a 65% discount to its target price. That implies 188% upside, not to mention a 6% dividend yield if the board reinstates the dividend to pre-COVID levels. As investor concerns are allayed you will see a recovery in Delta’s share price.

That said, there is likely to be some overhang on the stock for the next 3-5 years due to 2 things: 1) oversupply of aircraft and price competition, and 2) investor concerns about changes in corporate and consumer travel behavior. The first is easy to monitor (fleet size, new aircraft orders, PRASMs), and the industry can adjust supply to equal demand over the next 5 years. The second is much more difficult to quantify, and current projections are suffering from massive availability bias. Wall Street analysts are decrying the end of corporate travel (domestic traffic is 70/30 leisure/business, but revenue is 40/60), citing cost savings for businesses and how work-from-home convenience has changed travel preferences. Just six months ago, these same analysts pronounced the end of cyclicality in air travel, saying demand would continue to rise even in a recession. Wall Street is subject to overextrapolating recent trends, and work-from-home is definitely top of mind at the moment. Will corporate travel take a hit? Undoubtedly yes. Will it be anywhere near as bad as analysts think today? Absolutely not. Airlines are predicting RPMs to return to pre-COVID levels in roughly 3-5 years, and the IATA is predicting domestic RPMs to recover in late 2021 and international RPMs to recover in 2024. Once RPMs start reaching pre-COVID levels analysts will be mollified.

US full service carriers are best positioned in the global value chain: The airline industry is being impacted by COVID globally, not just in the US. So why pick Delta, a US carrier, or even an airline at all? Using a top down approach we can filter the potential investment universe to the most attractive stocks. Fundamentally, airlines are experiencing the strongest tailwinds, with industry consolidation increasing buying power and decreasing price competition, allowing them to take a bigger share of industry profits. Other sectors are less attractive:

• OEM economics are challenged by high costs, long production cycles, difficulty predicting the market, and sunk cost pricing fallacies. Furthermore, Boeing is struggling with its MAX grounding and safety issues.
• Aircraft leasing companies have much lower ROAs, finance is a commodity.
• Software companies (AMS, SABR) are being disrupted by startups and IATA’s NDC.
• Airports have limited upside as they can only raise tariffs and concession fees so much, failing to take full advantage of RPM growth.

When looking within airlines, international carriers face a host of challenges that make them relatively less attractive than US carriers:

• Many European airlines are state owned or partially state owned after receiving a bailout (Lufthansa 25%, Air France-KLM 14%, Alitalia 100%, Aeroflot 51%) while others are finally toppling from competition with Ryanair (Norwegian equitized debt). State owned airlines will struggle to balance right-sizing with government objectives (retaining workers), and are losing share to Ryanair.
• Latin American airlines are facing headwinds from currency depreciation, a trend accelerated by COVID.
• Southeast Asian airlines (Singapore Airlines, AirAsia) are being .disintermediated as a connecting stop by the rise of Middle Eastern airlines (Emirates, Qatar Airways).
• Chinese airlines have heightened risk from another virus outbreak (Bird Flu in 1997, SARS in 2003, COVID-13 in 2020 all originated in China) and are subject to the whims of the government.

This narrows it down to US carriers, plus Ryanair in EU. Amongst these carriers, you can choose b/w LCCs and full service models. LCCs have great business models, better balance sheets, will recover faster (greater domestic share), and will likely take share in the recovery. This is well known amongst investors, which explains why their stocks haven’t declined as much during COVID and hence don’t present as much upside opportunity. Also, in the long-term as LCCs expand out of their home markets returns will decline (this is already happening – can’t have a 15 minute turnaround time at JFK). LCC managements are empire building rather than maximizing shareholder returns, something to stay away from. This leaves us to pick from US based full service airlines. AAL is overlevered, and UAL is poorly managed. This leaves us with Delta.

Delta is best-in-class and COVID accelerates self-help opportunities:

Delta is also the top pick using a bottoms up approach. Delta is a best-in-class operator with significant advantages over its competitors that’s well positioned for the post-COVID recovery. The three most important themes for Delta are: 3A) Consolidation strategy, 3B) Low cost hubs, 3C) Acceleration of restructuring initiatives.

3A) Consolidation has transformed the airline industry over the last 10 years, with return on capital exceeding the cost of capital for the first time in 2015 and every year since then. Consolidation has resulted in more buying power and less price competition amongst airlines. In the US, mergers have increased the top 4 airlines market share to 90%, and 50% internationally. Airlines are consolidating internationally as well – doing deals that range from M&A and JVs to forming alliances and codesharing. Most famously the three main alliances (Star, SkyTeam, Oneworld) control 82% of the passenger traffic b/w the US and EU.

Delta has been a leader in international consolidation, taking five stakes in equity partners and forming a number of JVs (Aeromexico - 51%, Virgin Atlantic - 49%, China Eastern - 3.6%, Korean Air - 9.4%, LATAM - 20%, Virgin Australia – JV, WestJet – JV). Most importantly, it is increasing coordination on cost saving and yield management strategies b/w the partners. Taking a minority stake in an airline without more coordination, as many of its competitors are doing, doesn’t benefit shareholders. If Delta achieves just a 0-5% superior revenue quality and 0-5% structural cost savings from its consolidation strategies, it would become 10% more price competitive than the rest of the industry. This would hurt the competitiveness, and margins, of rivals. Here are some of the key advantages of consolidation:

• Representation on the board of equity partners
• Movement of middle management and sharing of expertise b/w partners
• Global procurement partnerships to lower cost of aircraft/MRO, handling/catering, IT & Distribution
• Commercial co-operation including schedule co-ordination, product harmonisation, loyalty plan reciprocity, and further strategic investments to boost market presence and traffic flows further
• Lower financing costs and potential financial health gains for partners due to investment by Delta
• Revenue sharing, code sharing, and other infrastructure sharing agreements (i.e. using a partners check-in and boarding personnel at a foreign airport)

3B) Delta is the envy of all airlines, with the lowest cost and most efficient hubs (Delta’s Atlanta hub is cited as the most profitable in the industry). Delta’s hubs give it a built in margin and efficiency advantage, as you can see from a number of DOT reported KPIs:

• Higher percent of on-time arrivals (In 2019 - 86.6% vs. Southwest 84%, United 82%, American 80.5%), where each minute of delay can cost $80+ per plane
• Lowest cancellations rate (In 2019 - only 0.7% cancellations vs. 2.5% for Southwest, 2.5% American, and 2.4% United),
• Lowest number of mishandled bags amongst full service airlines (4.27 per 1,000 enplaned vs. 5.18 United, 6.94 American)
• Fewer extreme weather delays (0.22% vs. 0.41% American, 0.31% United, 0.20% Southwest)
• Atlanta has the lowest landing fee for a major airport ($0.82/1,000 lbs vs. Charlotte $0.87, SFO $4.87, O’Hare $7.87, $NYC 8-10)
• Aircraft expense % of total is ~130 bps lower than industry average, adjusted for rent
• 20% price premium in hubs it dominates (80% market share in Atlanta)

3C) COVID presents a once in a lifetime opportunity for management to rebuild the business from the ground up. United has already created a “Big Picture” role focused on post-COVID fallout, moving COO Greg Hart into the position. You can be sure managements across the airline industry are laser focused on restructuring the business right now. All the normal obstacles to business improvement and innovation have been removed (labor objections, existing contracts/relationships, internal politics, Wall Street targets), which will accelerate cost cutting and yield management initiatives over the next few years. Here are some of Delta’s most exciting post-COVID opportunities:

• Delta is transitioning to lower cost next generation aircraft (more fuel efficient engines, lighter bodies, less vibration, etc.), which will be drastically accelerated by COVID. Delta was forced to park its entire fleet during the lockdown. As travel resumes, it will put the lowest cost airplanes into service first, generating a step function improvement in margins. Delta will also retire entire fleets of higher cost legacy aircraft early, meaning higher margins are here to stay. In an extraordinary move, Delta has already retired its 10-year old 777s, normally a 30 year life. Delta will also be able to cannibalize its parked fleet for spare parts (especially engines, the most expensive but also the most fungible part on an aircraft), which will save it considerable maintenance expense.
• Full service carriers have yield management opportunities that can expand margins. Upselling is pure margin in many cases, with each 1% of unit revenue worth 7% in operating profit for Delta. Delta has been the leader in offering branded fares (cabin segmentation), but upselling has been limited by OTAs and GDSs with a focus on sorting by cost. Delta can incentivize OTAs and GDSs to allow upselling, shift more customers to DTC (already 45%), or work with tech startups to provide new distribution channels. The potential upselling opportunities are nearly endless, including onboard food/drinks, duty free purchases, use of Delta’s Sky Club Lounge, advanced boarding, baggage checking, cabin segmentation, etc.
• Delta renewed its credit card program with AMEX in 2019. As noted earlier, this program is valued at $38B (vs. United $21.9B) and spending is not tied to travel demand. Delta doesn’t disclose much about the program but we do know that it took a greater share of the economic benefits in the 2019 renegotiation, which have yet to be realized. Delta’s credit card program is a great asset with significant upside potential.
• Only ~19% of Delta’s workforce is unionized, mostly the pilots who are the least likely to be fired during layoffs (b/c most difficult hire/train when business returns). This is unique in the US airline industry. It also makes it easier for Delta to right-size its business by cutting headcount coming out of COVID. Delta currently has a labor deal with pilots until 2022 lowering the risk of near-term labor issues.
• Delta is the only player that can sell its excess MRO capacity to third-party carriers. Delta’s MRO facilities are based in its low cost Atlanta hub. COVID could present opportunities to take share in this business.
• Fuel costs are low and likely to stay low throughout the 3-5 year post-COVID recovery period given the Saudi/Russia led oil price war going on.

As you can see, Delta is a great business that's going to be even better on the other side of COVID. Buy it while its still on sale.