DAL - Delta Air Lines: Downgrading To A Sell On Amplified Risks

2023-09-15 03:29:23 ET

Summary

• Delta Air Lines is downgraded from a hold to a sell due to amplified risks, including rising oil prices and potential macroeconomic headwinds.
• Airfare data shows a continued decline in prices, indicating a moderation in demand for travel.
• Weakness in consumer finances, including rising delinquency rates, declining household savings, and increasing unemployment, further contribute to the negative headwinds for DAL.

Introduction

In my previous article , I downgraded Delta Air Lines ( DAL ) from a strong buy to a hold. At the time, my reasoning behind the downgrade was due to a potential demand headwind forming along with the risks associated with rising oil prices. Since my last article, I believe the risks that I have pointed out not only hold, but the risks have significantly amplified. Oil prices are significantly higher with a strong possibility of the price continuing to increase throughout 2023 creating a strong headwind for Delta Air Lines. Further, the price deceleration trend of airfares has continued as shown in recent data, which likely signals a continued demand headwind as the economy slows. Therefore, as the initial potential risks that I have pointed out were further amplified, I am downgrading Delta Air Lines to a sell from a hold.

Demand

For the past few years, demand for travel has been extremely strong. Consumers valued services and experiences over physical goods driven by the monumental shift brought to consumers during the pandemic and its lockdowns. However, I believe these demands are starting to moderate with a potential for the demand to further slowdown going forward for the foreseeable future.

On September 13th, CPI data was released for August 2023. While the overall inflation showed signs of reignition, airfare data showed a vastly different picture. The overall inflation rose to 3.7% year-over-year with a month-over-month increase reaching 0.6%. The data is higher than the previous month's CPI data, which showed a month-over-month increase of 0.2% and a year-over-year increase of 3.2%.

Airfares , on the other hand, showed signs of weakness. Year-over-year, the airline fares declined -13.3% or -2.8% month-over-month. It is true that the month-over-month decline decelerated as July CPI data showed that the monthly price decrease was -8.1%; however, the decline in prices continued to be profound.

Obviously, price and demand are related. In times of strong demand, price tends to be high while low demand results in weaker pricing. Thus, I believe it is reasonable to argue that airlines are experiencing a moderation in demand from looking at continued weakness in the airlines' pricing power. No for-profit business will lower the prices of its services or goods unless the demand is weak.

Oil Prices

In a previous article, I pointed out the potential risks of rising oil prices. At the time, I was concerned by the actions of the OPEC+ led by Saudi Arabia. Saudi Arabia has continued its voluntary cut of 1 million barrels per day to limit the supply in hopes of raising the price of oil. I believed that these actions by such an influential player in the market signified that it would likely be hard for the oil prices to remain at relatively low levels. Since then, Saudi Arabia has announced that the country will extend the 1 million barrels per day cut until the end of 2023 , which is an aggressive move as the country only extended it by a month or two in the previous months.

I believe the message Saudi Arabia is sending to the oil markets is clearer today. The country will do everything in its power to limit the supply in the market to elevate the oil prices. In the short-term, with Russia also joining the move alongside Saudi Arabia with a 300,000 barrels per day cut, the oil prices will likely continue to move upward negatively impacting the airline industry.

The impact of higher oil prices is profound for Delta Air Lines. As proof, American Airlines ( AAL ), Delta Air Lines' industry peer, on September 13th, reduced its third-quarter forecasted profits from 90 cents per share to 20 to 30 cents per share. The dramatic cut in the forecasted profit came from higher oil costs and renewed labor contracts. As such, it is highly likely that Delta Air Lines to be similarly impacted despite the company having a refinery footprint to hedge the increase in the cost of the oil price.

Overall, oil prices will have a profound impact on Delta Airline's operations, and with the price significantly higher than in previous quarters with an expectation for the higher price environment to continue, I believe it is highly likely for Delta Air Lines to experience increased cost headwinds going forward.

Other Macroeconomic Factors

As said earlier in the article, due to the continued weakness in airline pricing as shown in the CPI data, I argued that the demand is likely moderating today. Looking at vast macroeconomic data, I believe the headwind from demand will not only continue but potentially worsen in the coming months.

Consumer finances are getting weaker. Federal Reserve St. Louis 's data on delinquency rates on consumer loans shows that consumer loan delinquencies are rising at a brisk pace. As the chart below shows, the acceleration in delinquency rates has been ongoing for the past few quarters and has almost reached the pre-pandemic levels.

Further, another point of weakness in consumer finances is the household savings data. After a dramatic rise during the pandemic due to multiple stimulus packages, household savings have declined extremely fast as consumers combated with high inflation shown in the chart below by the U.S. Bureau of Economic Analysis .

Finally, the recent rise in the unemployment data also signifies that consumer finances will continue to weaken. During and years directly following the pandemic, unemployment rates have been extremely low as many employers struggled to find employees. However, in recent months, the labor market has been cooling down, which is shown in the chart below. According to the data from the U.S. Bureau of Labor Statistics , the monthly U.S. unemployment rate has continued to climb in recent months to 3.8% shown by the chart below.

This trend could continue higher as the Federal Reserve continues to keep rates high to combat the sticky inflation. The most recent data, as said earlier, showed reignition in the inflation rate. This could mean higher rates or current high rates for a longer period of time, but whatever the Federal Reserve decides to do, the economy will need to cool down further in a high-interest rate environment for the Federal Reserve to achieve its goal. Therefore, I believe the current weak economic data have the potential to worsen going forward further weakening the consumers, which will likely impact the travel demand as travel is discretionary.

Impact on Delta Airlines

As I was writing this article, on September 14th, Delta Air Lines slashed its profit forecast citing higher oil prices from $2.20 - $2.50 to $1.85 - $2.05 range. This clearly shows the profound impact oil prices have on the airline, and with a potential for oil market conditions to worsen along with macroeconomic conditions, I believe the impact on earnings could be impacted further in the following months.

Risk to Thesis: Delta's View

Despite potential macroeconomic headwinds forming, Delta Air Lines' management team remains optimistic. During Delta's 2023Q2 earnings report on July 13th, the management team said that the company is "increasing [the] 2023 earnings guidance to $6 to $7 per share" citing that the "consumer demand for air travel remains robust." Then, on September 14th during a Morgan Stanley's ( MS ) conference , the management team reaffirmed a strong demand by saying that demand "stability has been displayed through the entire 3Q" as the company "ran a record high premium paid load factor domestically." The company also said that business and international travel demand continued to stay robust.

While the management cut forecasted profit due to a higher oil price, the company continues to experience strong demand. However, similar to the company downgrading forecast months after increasing guidance, I believe the macroeconomic factor will slowly start to affect the company in the coming months. Whether the macroeconomic factor is determined to be true or not, investors should be aware that the company continues to experience robust demand to date.

Summary

The market condition has gotten profoundly worse for Delta Air Lines since my previous article. Not only is the price decline continuing, which could be a sign of moderating travel demand, but the macroeconomic factors are creating a negative headwind for the company. Oil prices are significantly more elevated with a potential for the price to move higher in the coming months while consumers are showing signs of weakness in unemployment data, personal savings data, and consumer delinquency rates. Therefore, considering these factors, I am downgrading Delta Airlines from a hold to a sell.

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