DLAKF - Deutsche Lufthansa: Upcoming Catalyst Is Performance In Summer

2023-06-15 02:09:13 ET

Summary

• DLAKF is well-positioned to benefit from the travel recovery and strong summer demand, with a robust balance sheet and net debt to EBITDA ratio below the industry average.
• I expect DLAKF to see improvements in unit costs and a surge in corporate volumes throughout the year.
• The strong balance sheet allows for potential capital returns to shareholders, with an additional $2.8 billion in cash if the net debt to EBITDA ratio is maintained in FY24.

Overview

Deutsche Lufthansa ( OTCQX:DLAKF ) continues to be a buy in my opinion . This is a very straightforward story that was impacted by COVID and now is well-positioned to take advantage of the upswing from high air travel (from travel recovery) and pricing, supported by a very strong balance sheet. In my opinion, the stock's next major catalyst will be the season of summer (2nd and 3rd quarters). The fact that management sounds so assured about the robustness of summer demand and full-year consensus forecasts and about the possibility of reaching an 8% EBIT margin in 2024 is encouraging. While the stock price has fallen since March, I see this as a good opportunity to buy in ahead of what could be a very strong performance in the next two quarters, which could lead to strong stock performance momentum. In addition, DLAFK's balance sheet is still very strong, with net debt to EBITDA of less than 2x, which is excellent compared to its peers whose ratio is greater than 2x.

Demand

I would not read too much into 1Q performance and use it as a point of extrapolation for the rest of the year because seasonality matters for airlines. The slowdown in the leisure industry, amplified by the current slowdown in corporate traffic, causes the first quarter to be the slowest of the year. In my opinion, the coming summer season will be the most important factor in the company's financial performance and stock price. Importantly, I believe that DLKAF has a good chance of exceeding expectations because I expect a surge in the recovery of corporate volumes, which was not seen in 1Q. To give some perspective, corporate volumes in 1Q23 were roughly 60% of 2019's levels. I expect corporate volumes to recover throughout the year in strong momentum as more businesses are reducing WFH arrangements .

Margin

I expect an improvement in unit costs throughout 2023, despite the fact that they were weak in 1Q23 due to factors such as front-loading of OPEX to prepare for the summer season and disruptions caused by strikes. This accords with management's reiteration of 2024 as the year for which they aim to achieve a margin of >=8%. Despite the more difficult economic environment, DLAKF's management was confident enough to say so during the call. In the long run, I think it is possible to reach the goal through well-executed plans to reduce unit costs (excluding fuel) brought about by expanded production capabilities and enhanced efficiency. While I agree with the overall goal, I worry that the slow recovery in capacity, guided at 82% of 2019 levels for 2Q23, could make it more difficult to bring down the cost per available seat kilometer [CASK] excluding fuel in that year. Additionally, the recent comments from Fraport's management in 1Q23 earnings call could have an effect on Lufthansa's CASK cuts for 2024, which count on inflation slowing:

To the charges, yes, to the charges. Again, we -- in this year, it's -- we have now this 4.9% increase as of January 1st in this year. And in the next couple of weeks, you will hear what will come from -- for 2024. And I mentioned the impact of the wage tariff agreement 8% to 9%, and I'm not willing to give you now exact number, but based on the philosophy that we are growing and have to pass through is inflation driven wage increases, this is determining so to say the level of the price in the fee increase in '24. So your fantasy is open, It will be not more than 10%. It will be a single-digit number, much higher than the 4.9% which you saw and see in 2023.

Balance sheet

DLAKF's balance sheet remains strong, both relative to peers and in absolute terms. When compared to peers, net debt to EBITDA is now at 1.8x, which is higher than the industry average of 2x. If the net debt level is carried forward from the LTM level to FY24, the net debt to EBITDA ratio falls to 1.3x (assuming no debt paydown). This allows DLAKF to use its underlevered balance sheet to return capital to shareholders. According to my calculations, if DLAKF maintains its net debt to EBITDA ratio in FY24, it will have an additional $2.8 billion in cash. If all of these are returned to shareholders through share buybacks, they will account for approximately 25% of the current share outstanding.

Valuation

DLAKF stock now trades at 3.7x FY23 EBITDA of EUR4.8 billion (13% EBTIDA margin). The return of EBITDA margin to ~13% is key here to support the current 3.7x multiple that is in line with peers. If margin improvement initiatives do not realise as expected, then, DLAKF could go from trading in line with peers to being overvalued. Given my belief that EBITDA will continue to increase as margin increase and travel recovers, I believe the upside remains attractive if we apply the same multiple to FY25 EBITDA. 3.7x on EUR5.5 billion translates to a share price of EUR11.50, or 21% upside from today’s share price.

Risks

The risk here is a mis-execution in margin initiatives and a slower than expected recovery in travel in the near-term. This will impact consensus near-term estimates which will impact the stock narrative. A very bearish narrative could form like: Margins recovery slower than expected with possible structural change to air travel (since recovery pace slower than expected).

Conclusion

In conclusion, DLAKF remains a favorable investment opportunity in my view. The company's strong balance sheet positions it well to benefit from the anticipated rebound in air travel and pricing as travel restrictions ease. Despite the recent decline in stock price, I see this as an opportune moment to invest, as I expect the upcoming summer season to be a significant catalyst for the business and stock price. Furthermore, DLAKF's solid balance sheet, with a net debt to EBITDA ratio below industry average, allows for potential capital returns to shareholders.

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