2023-07-06 10:19:18 ET
Summary
- Delta stock outperformed its industry peers and many market indices in June 2023 and over the past year.
- Delta Air Lines continues to outperform in the post-COVID economy and recently affirmed its previous profit and cash flow guidance at the high end of guidance.
- Delta's strong performance is attributed to its revenue generation ability, partnerships and capital management and people-focused strategies.
As the U.S. and global economy as well as the U.S. airline industry continues to find its new post-covid normal, Delta Air Lines (DAL) continues to stand out as one of the strongest performing consumer and industrial companies, two industries in which it is frequently classified. Airlines are old-line companies with Delta as the U.S.'s oldest airline, within years of celebrating its 100th birthday. Delta recently held its 2023 Investor Day in Atlanta, inviting Wall Street analysts to Atlanta to tour its facilities but also to hear presentations from a number of executives, the latter of which was available to the rest of the world. In its investor day presentation, Delta affirmed its profit and cash flow guidance for the quarter and year but noted that both are expected to come in at the high end of its previous guidance.
The first half of 2023 was very good for DAL stock and June 2023 was even better relative to its peers and broader market indices. Delta gained 31% in the month of June and 64% in the past year. In December 2022, I wrote in this Seeking Alpha article Delta Air Lines Stock: New Planes, Pilots, Partnerships To Fuel Profit that Delta's strengthened financial performance would be driven by its revenue generation ability, its partnerships, its ability to attract new pilots to support its growth plans, and new airplanes. Since that article, DAL stock has gained 31%, far outpacing the S&P 500. My ratings history for DAL shows an ability to see stock opportunity that could have led to significant opportunity for investors. Let's look at the factors I continue to look at for DAL and why the outlook for the Atlanta-based global airline remains very bullish.
First, throughout the pandemic, several industry dynamics were setting up that would lead the U.S. airline industry to a very strong rebound. The U.S. pumped trillions of dollars into the U.S. economy which succeeded at preventing a potentially devastating economic collapse. There are multiple metrics showing that the stimulus to the economy fueled consumer spending that carried the U.S. economy until economic stability.
However, there were dynamics that were unique to the airline industry. Global travel was decimated during the early months of the pandemic but the United States did not lock down movement of its people to anywhere near the same degree as happened in many countries. Despite this, spending on air travel fell well below historic norms and is only now beginning to return to those historic ratios to GDP. Multiple airline executives including those at Delta have noted that there would be a very strong rebound in travel and that has been occurring since domestic travel began to rebound fifteen months ago followed by reopening of global travel which continues to this day. Changing work habits have stimulated high-end leisure and mixed business/leisure spending more than the amount from lost business travel.
Specific to the U.S. airline industry, multiple industry analysts stated throughout the pandemic that domestic-focused and low cost carriers would gain an advantage over global airlines including AAL, DAL and UAL in the U.S. I repeatedly countered including in this Seeking Alpha article that the big 3 U.S. global airlines also compete in the domestic marketplace and are generally more capable of reducing costs to match reduced revenues than low cost carriers which are dependent on growth to keep their costs down. In the lack of growth opportunities for much of the pandemic, high pre-pandemic low-cost carrier margins evaporated.
Post COVID, the U.S. airline industry has been confronted with multiple increased cost pressures including from reduced labor force participation and the retirement of tens of thousands of skilled airline employees during the pandemic that have needed to be replaced now that demand has returned. Although fuel prices have stabilized to lower levels, a significant increase in fuel costs including shifts in refinery production as a result of shifting fuel demand patterns led to disproportionately higher costs for jet fuel than for other petroleum products - negatively impacting airlines. Low-cost carriers are less able to absorb higher costs than legacy peers in part because the latter group of airlines is more successful in passing along higher costs to consumers through a more diverse portfolio of services including premium products which are increasingly being sought by a growing number of consumers.
Against the backdrop of macroeconomic and industry-specific dynamics, there are a number of Delta-specific reasons that explain why DAL outperformed the industry in 2023 year to date. Different airlines including each of the big 3 U.S. global carriers took significantly different strategies to survive the pandemic and to set themselves up to grow after the pandemic. American ( AAL ) had long been one of the weakest airlines financially driven by large stock buybacks even when the company produced low profits. It aggressively bought new aircraft during much of the 2010s to replace its fleet which aged significantly post 9/11, dramatically increasing debt; AAL still stands as one of the most indebted U.S. airlines but is rapidly working to pay down its debt by dramatically slowing its fleet spending. In addition, AAL had a long history of flying unprofitable routes including across the Pacific, leading to significant losses on many parts of its international route system according to DOT data.
United ( UAL ) experienced a significant reshuffling of its executive suite in the 2010s which resulted in significant changes to a number of its strategies. A result of a megamerger with Continental Airlines, United's domestic network was heavily dependent on small regional jets, giving it relatively low market shares outside of its major hubs. United also has prided itself as being a heavily international airline although industry financial history shows that the domestic market has been more consistently profitable for U.S. airlines. UAL also remained in a number of markets in the late 2010s, including in China and Hong Kong, even as the economic situation in those markets began to deteriorate, resulting in losses across UAL's Pacific network, although not as deep as American's. Finally, UAL has had a challenging history with its employees for many years and also had a checkered customer service reputation but short-term CEO Oscar Munoz worked hard to rebuild both of those relationships. While current CEO Scott Kirby has a history in his tenure at former airlines as not advancing employee and customer relations, he has implemented an aggressive growth strategy that seeks to address UAL's relative domestic system weakness and to more intelligently grow its international presence but is straining the company's current performance and future finances in order to achieve goals that UAL might not be able to competitively achieve.
Delta's strategies, especially relative to its two primary U.S. global competitors are being driven by decisions the company made years ago and which are now beginning to bear much more fruit given the chances that have confronted global and the U.S. economy and the airline industry.
Delta's Distinctive Premium Revenue Strategy
Most notable among Delta's distinctives that have allowed it to quickly outperform is its focus on a return to its premium revenue strategy, not just with respect to passenger revenue but also with non-transportation revenues that its peers cannot match. On the passenger revenue side of the equation, Delta has long enjoyed strong revenue dynamics due to its market strength in its core hubs including Atlanta (where Delta operates the world's largest and highest revenue airline hub), Detroit, Minneapolis/St. Paul and Salt Lake City; Delta has more than 60% local market revenue share in each of those markets which each also only have one major commercial airport, a distinct advantage compared to its peers. In addition, Delta began the shift to increasing the revenue it gets from sources other than standard coach revenue - which all airlines chase - before the pandemic and has strengthened their execution against that goal over the past 15 months post-pandemic; Delta says it now gets more revenue from its premium seats (everything other than its standard economy seats) than it does from standard economy even though the majority of real estate on every Delta plane is standard economy. Delta continues to add premium cabin seats to its fleet reflecting a strong and growing consumer willingness to pay for an upgraded travel experience.
In its investor presentation, Delta notes government statistics that show that 75% of airline revenue comes from the top 40% of Americans or those above $100k in household income. Despite repeated fears from economists that the airline industry would be subject to recessionary pressures and to inflation, Delta has successfully focused on a segment of consumers that are least impacted by macroeconomic forces. Delta's passenger revenue trends are not unlike what peers American and United are seeing, including a shift to premium services, but to a greater degree. Delta's international network continues to develop around its international joint venture partners, saying that flights to those partner hubs generate margins twice as high as the rest of Delta's international flights.
However, Delta's growing focus on non-transportation revenues is unique and is yielding significant profits; although Delta flew less capacity than other airlines in 2022 and in the first quarter of 2023, Delta generated more total revenue and that trend is expected to accelerate in the quarters and years ahead.
Although Delta was not the first U.S. airline to introduce a loyalty program or credit card partnership, it has excelled beyond its peers in extracting financial benefits from those programs. Delta says that it is enrolling one million new members to its loyalty program each month in part because it has limited access to its new domestic free onboard WiFi to Skymiles members.
Delta also notes that it converts one in every eight Skymiles members to one of its American Express ( AXP ) cobrand credit cards. The Amex-Delta relationship has turned into the most valuable partner relationship in the global airline industry and is expected to deliver $6.5 billion in revenue (high single digits of DAL's total revenue) to Delta in 2023. Loyalty program revenue is much higher margin than transportation revenue. Despite trying to duplicate what Delta has with Amex, no other airline has provided a plan to match the revenue that Delta gets from its Amex relationship which supports investments in Delta's business and employees which no other airline can touch.
Delta also noted in its presentation that it is increasing its focus on aircraft maintenance services - MRO - for other airlines which it performs through its maintenance division, Delta Tech Ops, which I have featured in previous SA articles. Delta Tech Ops is the largest airline MRO in the western hemisphere and one of the largest in the world. By insourcing aircraft maintenance work from other airlines, particularly focused on high-margin engine and component overhauls, Delta not only essentially subsidizes the cost of maintenance on its own fleet - which is the lowest per seat mile of any U.S. competitor - but also brings in valuable revenue. While Delta does not report Delta Tech Ops revenue or profits separately - it is a division, not even a subsidiary of DAL - their latest presentation shows that they expect to generate $800 million in revenues for the division in 2023. Assuming net margins in the high teens, Delta Tech Ops now contributes profits of a couple hundred million dollars/year. Delta noted that it has received manufacturer rights to service three of the airline industry's new generation engines which will be installed on more than 50% of the global commercial aircraft fleet by 2032. Delta expects Tech Ops to generate more than $5 billion in revenues, implying a profit contribution of more than $1 billion within seven years.
The power of maintenance overhaul rights is playing out right now as Delta attempts to place a large order for new widebody, international aircraft. Delta has been trying to firm up an order for new Airbus (EADSY) A350-1000s and A330-900s but has been stymied with latest indications that Rolls-Royce (RYCEY), exclusive supplier of engines for the A350, the largest and most capable in-service all-new generation widebody, and for the A330NEO (-900) will not grant Delta maintenance overhaul rights for the largest version of the Trent XWB engines on the A350-1000 even though Delta has those rights for the engine that powers the A350-900 and the A330-900 which are already in Delta's fleet. As I noted in this recent article on Airbus, Airbus Fights To Win Big Delta Order - Buy Rating Regardless , Boeing ( BA ) is aggressively competing for the Delta order and with General Electric ( GE ), has placed an offer on the table for the B787 that includes maintenance rights for the GEnx engines that are an option to power the B787 family.
Delta is now evaluating both options. Adding the B787 to Delta would add significant operational complexity - Delta has repeatedly said it wants to consolidate its new generation widebody fleet around Airbus models - but the offer from Boeing and GE opens the door to large amounts of future engine maintenance revenues which could offset the increased operational costs which Delta would incur by adding the B787 to its fleet. In addition, the B787 is smaller and less capable than comparable A350 models so there is a potential revenue loss that Delta has to consider. The power of MRO rights could not only decide this next widebody order as has never occurred for any other U.S. airline but will certainly give Delta a total fleet cost advantage compared to virtually any airline in the world when Delta Tech Ops revenues are considered.
Industry Leading Capital Management Strategies
Delta's fleet strategy is just part of what many consider to be one of its greatest strengths - its capital management strategy. Specific to its fleet, Delta has long been known to balance multiple types of strategies to produce some of the lowest fleet costs per seat mile in the industry. Delta often opportunistically buys new aircraft in smaller batches and greater frequency than comparably sized airlines. Delta's new aircraft buying often swings from deals that involve low prices for end of production models or being first in line for new, advanced technology models. In addition to its new aircraft strategy, Delta frequently buys used current generation aircraft at significant discounts. During the pandemic, Delta bought scores of new and used Airbus widebodies and Boeing narrowbody aircraft at deep discounts and have put them in service faster than new aircraft could have been delivered. Finally, Delta is boosting its current fleet by reactivating aircraft that it parked during the pandemic, either temporarily or by reversing plans to permanently retire some fleet types.
Delta's capital management strategy has also including accelerating pay down debt. Delta notes that its adjusted debt was 2X EBITDAR pre-COVID, will be at 3X this year, and should be at or below 2.5X in 2024. Delta is also using its $3 billion in free cash flow this year and more than $4 billion next year to reinstitute a dividend, part of its strategy for DAL stock to be viewed as an investment rather than a trading stock as many airline stocks are seen.
Delta is a People-Focused Company
The final characteristic to highlight is that Delta is a people-focused company both for customers and employees. Delta has long recognized the value of superior customer service and has widened the gap between itself and its competitors in proving better customer service in an environment where there is abundant public criticism. The Dept. of Transportation has long compiled complaints from passengers about airline service and, while they are taking longer to post data, final data from 2022 shows that Delta is delivering a substantially higher quality level of service than any other large jet airline.
The level of customer service that Delta delivers translates in part to its ability to command a revenue premium. That revenue premium, in turn, allows it to pay its employees higher wages than Delta's peers.
The post-COVID labor environment has been challenging for many companies but no industry has struggled any more than airlines. Heavily dependent both on significant numbers of high paid, skilled workers and also the requirement to provide high quality levels of service, airlines have been squeezed by labor cost inflation. Delta has figured out better than its peers how to afford high labor costs while ensuring the supply of new workers.
Airline labor contracts under federal law do not expire but become amendable and most airline labor contracts became amendable during the pandemic. Both management and labor understood that there was no value in continuing negotiations during the pandemic but labor was quick to want to return to the negotiating table as soon as demand roared back - which it certainly has.
Although United's CEO said 18 months ago that he would sign the industry's first post-COVID pilot contract and it would be industry leading, Delta management broke through with a contract for its pilots in December 2022 that included more than $750 million in retroactive pay - which was paid in the first quarter of 2023 - and pay raises that will boost DAL's costs by billions of dollars per year, including the raises it also gave the remainder of its employees, most of which are not unionized. DAL's favorable guidance is particularly impressive given that none of American, Southwest or United have implemented salary increases for as many workers or as large as what Delta has agreed to; Delta can clearly afford its pay raises because of its unique revenue environment while other airlines will struggle to absorb the same level of increased costs.
Growing Financial Leadership
DAL stock had very strong recommendations before June and the multiple positive reports from the company during the month are certain to lead to continued acceleration. Delta said it expects to reach $6 in earnings per share in 2023, setting up the possibility to exceed Wall Street estimates. In 2024, DAL believes it will earn more than $7 per share, while generating more than $4 billion in free cash with a return on invested capital in the mid-teens.
Further, as other airlines continue to struggle in the execution of their strategies, DAL's much stronger execution and growing revenue premium as well as addition of more non-transportation revenue which other airlines cannot match will lead to further growth of Delta's earnings and valuation premium over its competitors. DAL has the highest market cap of any U.S. airline, having just broken through the $30 billion mark, resulting in a 40% premium to second place LUV and a 70% premium to UAL.
Delta has seen its stock upgraded in recent weeks and sports one of the strongest recommendations across Wall Street and Seeking Alpha analysts as well as SA's Quant system. More significantly, Delta is quickly repositioning itself post-COVID as one of the financially strongest airlines in the world and also a true investment in an industry where airlines are rarely viewed as investments.
For further details see:
Delta Air Lines Proves It Is A High-Quality Investment