Description

Full disclosure: I submitted a DAL long write-up on 2/19/18 as my VIC application idea.  After being accepted to VIC, I saw that "nilnevik" posted DAL long on 2/23/18. Per VIC guidelines, I am unable to post under DAL again. While I like DAL as an outright long, I am actually expressing DAL as a net long pair trade in my portfolio against a basket of UAL and AAL. Given that significant portion of my analysis hinges on UAL, I thought it would be appropriate to file my analysis under UAL.

Investment Recommendation

Delta Airlines is a compelling long investment with over 40% upside to current stock price.  The stock trades at 8.5x 2018 consensus EPS and 7.5x 2019 consensus EPS.  My target price of $76 is predicated on a 12x target PE multiple on 2018 EPS, derived from a 10x target NTM PE multiple for legacy peers (AAL and UAL) plus a 2x valuation premium for DAL.  The following write-up will explore the current state of the industry followed by a detailed competitive analysis on DAL.  My investment recommendation is both an absolute and relative valuation call on DAL.  The market is offering us a rare opportunity to buy the best in class airline for the cheapest valuation multiple (DAL is 8.3x vs. AAL at 9.4x and UAL at 9.1x EPS).

Industry Thoughts and Current Situation

The airline industry has a long history of capital destruction.  Back in 2007, Warren Buffet famously said:

“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

The reputation is well deserved and value investors have been largely correct to avoid investing in airlines for a period of approximately 30 years following deregulation in the late 1970s.  That being said, this investment recommendation is not predicated on some belief that the airline industry is fundamentally misvalued – it is not.  Certainly the industry has fundamentally changed from the days of perpetual capital destruction and has learned some valuable lessons.  It is now an oligopoly that lacks pricing power.  The business is very cyclical with tremendous operating leverage.  Most management teams understand this reality and have adopted conservative capital structures.  Another positive is that the legacy airlines are becoming more shareholder friendly at returning capital to shareholders via dividends and buybacks.  The one big problem that remains is that almost everyone is still addicted to capacity growth… and on January 23, 2018, United Airline dropped the MOAB of capacity bombs.

Some background first.  UAL is the ugly red headed step-child of big the 3.  While it was the 2nd to exit bankruptcy after DAL, it remains a fixer upper with a margin profile significantly lower than peers.  Under previous management, UAL did not grow capacity very much and embarked on an up-gauging strategy that was RASM (a measure of unit revenues – “revenue per average seat mile”) accretive but long term margin dilutive.  They even got to a point where they justified using wide-body Boeing 777s for hub to hub domestic flying.  Then in September 2015, then CEO Jeff Smisek abruptly resigned over accusations he attempted to influence officials at the Port Authority.  Board Member and then CFO of CSX, Oscar Munoz stepped in as CEO.  The UAL board didn’t really do a proper search, and Oscar didn’t really have any airlines experience, so lots of shareholders were none too thrilled with the shotgun appointment.  To complicate matters further, shortly after assuming the position, Oscar had a heart attack, eventually requiring a heart transplant.  This ends up delaying UAL’s turnaround and an “activist” shows up (Par Capital).  Par eventually gets UAL board representation and has a hand in Oscar’s subsequent appointments to the executive team.  About a year later (August 2016), Scott Kirby loses the #2 slot at AAL, and is hired by UAL as the #2 to help execute the turnaround.

Fast forward to November 2016.  United hosts an investor day and makes a very bold claim: they will close the margin gap vs. DAL... in fact they will realize a 1.5pt margin premium by 2020 (slide 96).   Most of this will come from “commercial enhancements”.  UAL also discusses plans to grow capacity by 1-2% in 2017.  A few months later, UAL shocks investors in March 2017 with new plans to grow capacity by 2.5-3.5% in an attempt to re-claim their “natural” market share.  The incremental capacity is best described as a capacity reset to jump start UAL’s 4 year plan of closing the margin GAP vs. DAL.  However, through most of 2017, UAL underperforms on RASM and the margin gap actually widens.  Investor angst comes to a head on October 19, 2017 (3q17 earnings call) with the stock is down 12%.  UAL goes quiet after the call and many investors are calling for Oscar’s head.  By the end of 2017, UAL schedules a formal “investor day” for January 23rd – the same day they are supposed to announce 4Q17 results.  Two weeks before their scheduled investor day, UAL puts out a decent 4Q17 investor update on January 10, 2018 and the stock rallies into investor day.

Conventional wisdom says you don’t hire a sushi chef to cook you barbeque.  Well, Scott Kirby is a network planning guy and his middle name is “scorched earth”.  So the view that Scott Kirby would somehow restrain UAL’s capacity growth and that commercial enhancements alone would close the margin gap was a naïve view of the world.  Thus on January 23, 2018, UAL announced a 3-year capacity plan to grown ASM’s 4-6% on consolidated basis, and even higher domestically.  To quote the man himself, “A hub-and-spoke airline is really a manufacturing company and it is about manufacturing connections.  The more connections you can drive at a hub, the higher profit you drive that hub, and the more options you have for customers to flow through that hub.”  Kirby is obviously correct.  UAL’s prior strategy of up-gauging aircraft and reducing smaller gauge regional jets, came at a long term expense – sacrificing hub feed which dilutes the long term value of the network. The other major item to come out of UAL’s investor day was a complete 180 on the DAL margin gap closure narrative.

So this is why the airline sector is down year to date.  Domestic capacity growth is trending to nearly 2x GDP growth at the same time oil prices are at 2.5 year highs.  Airlines collectively “gave away” or “competed away” about two-thirds of the fuel savings on the way down, yet now put themselves in a position with no pricing power due to their collective capacity actions.  That’s why airlines don’t deserve a valuation higher than 10x earnings.   To be fair, UAL does not deserve to get all the blame.  LUV is growing capacity by 5%, JBU by 8%, ALK by 7%, SAVE by 23%, ALGT by 12%.  So who is growing the least – that would be DAL and AAL at 3.0%.

So back to UAL because understanding UAL’s actions are key to having an industry view.  So UAL is going to beef up Newark and expand hub feed in Denver, Houston and Chicago.  For those of you with access to sell-side research, Hunter Keay from Wolfe Research recently published an exhaustive analysis of all the new hub feed flying UAL has added since January 2017 with in-depth analysis on the probability of each city pair’s success (published 2/16/18).  The spoiler is that Hunter thinks most of the new feed will fail and he thinks there is a decent chance we see a UAL pivot by 4Q18.  What was not directly addressed in this note is whether UAL can execute on their hub feed strategy with their current scope clause limitations.  To my knowledge, nobody on the street has done this analysis.  For those not familiar with airline pilot labor contracts, there is something called a scope clause which sets the limits airlines have in utilizing regional airlines crewed by non-mainline pilots.  You can read more about this here:

https://en.wikipedia.org/wiki/Scope_clause

The punchline is that AAL and DAL both have pretty liberal scope clauses, while UAL does not.  Scope clauses are very difficult to change.  According to Derek Kerr, AAL’s CFO, Scott Kirby pushed hard at AAL for scope relief with the pilots coming of out bankruptcy and it was a complete non-starter.  The issue I have with UAL’s new 3 year capacity plan is that I don’t believe they can execute it without either: 1) scope relief with significantly higher mainline pilot costs; or 2) a major aircraft order of C-series jets.

United Airlines’ pilot contract becomes amendable on January 2019.  If Kirby wants to get scope relief to add more 76-seat RJ’s he will need to pay pilot greenmail.  And if UAL’s CASM (unit costs) are going to leapfrog higher vs. AAL / DAL, this is going to be a big problem for their blue sky 2020 EPS guide.  The alternative is for Kirby to buy a bunch of 100-seat C-series and run them on the mainline for hub feed.  Either way, it is going them cost them.

To boil this all down, I think UAL is going to have a hard time executing on their growth plans.  Investor patience is limited and if UAL’s strategy does not start bearing fruit by 4Q18, some hard choice will have to be made.  The industry has re-rated lower on UAL’s multi-year capacity fears which are understandable.  In the meantime, there are several positive data points: 1) corporate fares are rebounding (good for big 3); 2) Transatlantic and Latin America markets are very strong (good for AAL, DAL); 3) domestic GDP likely to accelerate in 2018 with higher levels of disposable income due to tax reform; 4) weaker dollar helps airlines; and 5) 1Q18 RASM is tracking well.  So from an industry perspective, I think the sector is 10-20% cheap.  Certainly nothing to get excited about…

Thoughts on Oil

Airlines clearly over-earned when oil prices plummeted from $100 (mid 2014) to sub $30 (1Q16).  That being said, the industry competed away more than 50% (some estimate up to 66%) of the jet fuel savings by foolish capacity adds and competitive pricing actions as evidenced by back to back years (2015/2016) of negative unit revenues.  There are several points I would like to make:

1. The industry is largely on a level playing field with respect to oil prices and hedging programs.  Back in 2008, LUV had a massive hedge book and used it go on offense when oil prices spiked to $150 / barrel.  Similarly, in 2015, AAL was the only major with a no-hedge policy, and used the windfall fuel savings to go on offense against LUV (Wright amendment growth) and SAVE in 2015 / 2016.  Today, the big 3 do not hedge fuel.  And LUV has a very modest hedge book.  Consequently, the industry has a flattish oil cost curve with a collective incentive to grow unit revenues by raising prices / reducing capacity as oil prices rise.  My view is that this is this will happen with 6-9 month lag unless there is a 9/11 type demand shock to system.

2. From a valuation perspective, one could argue that current PE multiples (~8x) are discounting the potential for higher future oil prices.  However, it is interesting to note that oil prices are actually in backwardation.  This was not generally the case when oil prices were plummeting and airlines multiples were de-rating in 2015/2016 – the oil curve was in contango then.  My own view is that oil prices will remain range-bound ($60 +/- $10) due to OPEC politics and the ability for US shale producers to continue to grow production.

3. The big 3 have all given FY2018 EPS guides: DAL ($6.35-6.70), AAL ($5.50-6.50) and UAL ($6.50-8.50).  These guides embed very similar jet fuel prices consistent with the oil strip from mid-January.  UAL has guided $2.11, AAL has guided $2.06-2.12, while DAL has not explicitly guided full year.  Everyone has guided for 1Q18 – DAL ($2.05-2.10), AAL ($2.07-2.12) and UAL ($2.11).  Given the lack of hedges, you can approximate their jet fuel prices by adding 15-20 cents to the jet fuel prices you see on bloomberg “BOIL” screen.  While management teams can’t control fuel prices, they can control tickets prices and capacity. The optimist in me thinks this incrementally helpful in forcing management teams to do the right thing in a rising oil price environment.

4. The airline most vulnerable to an oil price shock is UAL (2018E EBIT margin = 7.8%), followed by AAL (2018E EBIT margin = 9.0%).  DAL is a distant third (2018E EBIT margin = 13.3%) and then LUV (2018E EBIT margin = 16.5%).  LUV is also most protected as they have modest hedges in 2018, but hedges drop off in 2019.

5. DAL is also insulated from a potential spike in jet fuel cracks due to their ownership of the Trainer Refinery.  While oil prices are in backwardation, distillate cracks are in contango due to IMO 2020.  Without getting too much into the weeds on this, global shipping companies are going to be forced to switch to low sulphur fuel which is estimated to create an additional 2mm bpd of distillate demand.  This means there is a real risk that jet fuel prices go up absent any further increase in oil prices.  No other airline owns a refinery.

6. Finally as oil prices go up, international fuel surcharges will come back.  This is not relevant the US domestic market but plays a role in internal flying and thus applicable to the big 3.

Delta Airlines

So how many companies are there in the S&P 500 that trade at less than 10x forward PE, carry investment grade ratings, and have dividend yields > 2%?  I count ten companies and here they are ranked by cheapest earnings multiple: GM, F, VIAB, DAL, SIG, XRX, M, PRU, ANDV, MET.  Say what you will about airlines, but over the next 10 years air traffic will almost certainly grow.  Unless we invent teleportation, obsolescence risk is low to the airline business model.

So the crux of my investment thesis is that DAL should trade at a 20% valuation premium to other legacies because DAL has either a structural advantage or massive lead on nearly everything that drives airlines profitability including: 1) network hub structure; 2) fleet strategy; 3) commercial initiatives; and 4) capital structure / durability of shareholder returns.  Lets review each in detail.

Network Hub Structure.  DAL thoroughly dominates its four largest hubs: Atlanta (78% share), Detroit (72% share), Minneapolis (69% share) and Salt Lake City (67% share).  Comparatively, AAL’s four largest hubs are DFW (86%), CLT (90%), ORD (40%) and PHX (46%), while UAL’s are IAH (79%), EWR (68%), ORD (47%), and DEN (42%). As you can see, UAL and AAL dominates a couple hubs each, but their 3rd and 4th largest hubs lack a majority market share.  Additionally with respect to AAL, both DFW (competes with Love Field) and ORD (competes with Chicago Midway) are two-airport markets.  Same issue with UAL’s IAH (competes with Dulles) and ORD (competes with Midway).  You could also make the case for EWR competing with JFK, but to be fair, UAL maintains an enviable hub position in Newark.

The value of the Atlanta hub cannot be understated – it is the crown jewel of DAL’s portfolio given its sheer size and decent mix of originating local traffic (53%) vs. being just a connection hub.  Atlanta is also not slot / gate constrained, is relatively low cost (eg. landing fees), has comparatively fewer ATC delays, and enjoys better weather than major hubs like NY and Chicago.  By virtue of geography, DAL has a meaningful and durable network advantage vs. AAL and UAL.

Fleet Strategy.  Delta has been a trailblazer in how they think about fleet.  The typical US airline just buys new planes whenever they need them.  Some airlines even become beholden to a single aircraft OEM due to their single aircraft type strategy (LUV / Boeing, JBLU / Airbus, ALK / Boeing, etc.).   Delta on the other hand, operates comparatively older planes and has in an-house MRO (maintenance, repair and overhaul) business.  And they are not shy about buying used planes.  DAL’s average aircraft age is 17.0 years vs. UAL at 14.3 and AAL at 10.8 years.  One would think that by flying relatively newer planes, both AAL and UAL would have better on-time performance and fewer cancellations than DAL.  That is simply not true – Delta’s tech ops is the industry gold standard.  In fact, DAL has attributed share gains among corporate accounts due in part to how they can run their planes on time.

By running planes to the end of their economic life, opportunistically buying used aircraft, and running an in-house MRO business, DAL is able to generate superior returns on invested capital and generating greater free cash flow to shareholders.  A few examples:

1. Delta effectively ran the MD88 ragged with amazing reliability.  This is a 80s/90s vintage plane.  ALGT also ran a large MD88 fleet and they had nowhere near the dispatch reliability that DAL was able to produce with their in-house MRO expertise.

2. Delta opportunistically took over Airtran’s Boeing 717 fleet from Southwest back in 2012.  DAL got a sweetheart deal with Southwest paying DAL $100 million alone to convert the livery and then subleasing the planes to DAL.  DAL in turn was able to use this unique plane to up-gauge its RJ fleet.

3. Last year, DAL ordered 75 C-series planes from Bombardier, effectively becoming the US launch customers for this airplane.  The C-series program was on life support so DAL basically named their own terms.  I think they paid close to $20 million / copy which is a steal.  This prompted Boeing to file a trade case against Bombardier which Boeing initially won, but the most recent ruling suggests no damages (because Boeing does not have a viable competitive alternative to the C-series to prove damages).  The C-series will replace the MD88s and eventually 717s.  Separately, I expect JBLU to announce a C-series order within the next 6 months, and UAL within the next 12 months.

4. Last December, DAL also ordered a bunch of Airbus A321neos.  But that wasn’t the most interesting part… DAL also configured the plane with the new Pratt GTF engine and was able to extract a MRO contract from Pratt to be the exclusive North American over-hauler for this engine.  This is very big deal.   According to DAL management, the total revenue opportunity for this contract is $15 billion over the life of contract.  Assuming it starts earning in the early 2020s, runs for 20 years and generates 15% EBITDA margins, this adds over $100 of annually recurring non-cyclical EBITDA for Delta.

So to summarize on fleet: 1) superior operations; 2) shrewd capital allocation generating greater than average industry returns and cash flow; and 3) a growing MRO engine business what will pay dividends for decades to come.  I would call most of this a structural advantage for DAL, but to be fair, UAL’s new CFO is making a real attempt to source used planes.

Commercial Strategies.  Delta has also been a pioneer in extracting additional revenue from their customer base.  They have a long list of industry “firsts”:

1. Converted their mileage loyalty program from a miles flown model to a hybrid revenue based model

2. Introduced basic economy fare class to more effectively compete with ULCCs without diluting main cabin yields

3. Introduced comfort plus in economy class

4. Made a concerted effort to increase paid load factors in 1st class

5. Rolling out “economy select” cabin class for international flights (similar to domestic business class).  Early results in transatlantic have been amazing – 85% paid load factors at 2x economy ASPs

I expect all of the above to be copy-catted by AAL / UAL.  However, I continue to expect DAL  to drive innovation and stay one step ahead.  The bad news is that once everyone “segments the cabin”, I expect some of this “alpha” to be competed away.  That is why it is imperative to stay a step ahead.

Capital Structure / Durability of Shareholder Returns.  This is pretty straightforward and requires little explanation.  DAL is investment grade, UAL and AAL are not.  DAL has net debt / EBITDAR of 1.1x while AAL is 3.4x and UAL is 2.1x.  DAL yields a 2.3% dividend, AAL yields 0.7% and UAL pays no dividend.  They all buy back stock but you can argue AAL has debt financed a decent portion of their share buybacks and thus pace is not as sustainable.  DAL offers investors a Free Cash Flow yield of 9% on 2018 and 10% on 2019.  AAL offers 6% FCF yield on 2018 and 3% yield on 2019, while UAL offers 4% FCF yield on 2018 and 1% yield on 2019.

Summary

Given all the points I have made, why is DAL trading cheaper than AAL / UAL?  I can offer a couple reasons:

1. I am using 2018 street consensus and the big 3 have provided full year EPS guides which the street has fully reflected.  If one can get comfortable using 2019 street EPS, the valuation gap is negligible (DAL at 7.52x, AAL at 7.77x and UAL at 7.61x).  However, my variant view is that 2019 numbers cannot yet be believed.  There are too many variables and the business models have too much operational leverage for this type of precision.  For example, an oil price spike would disproportionately hurt UAL within the group because they have the worst relative margins to begin with.  Additionally, from a competitive perspective, AAL has the most network overlap with UAL and is most susceptible to revenue dilution given UAL’s stated capacity actions.  Simply put, I don’t have much confidence in 2019 numbers given the potential dispersion of outcomes.

2. Post UAL’s capacity announcement on January 23rd, long only investors gave up on airlines.  And the consensus favorites amongst the long only community were the “safer names”: Delta and Southwest.  Coincidentally performance YTD is as follows: AAL up 4.3%.  UAL up 0.6%.  DAL down 3.8%.  LUV down 11.6%.

Investment Recommendation

Delta Airlines is a compelling long investment with over 40% upside to current stock price.  The stock trades at 8.5x 2018 consensus EPS and 7.5x 2019 consensus EPS.  My target price of $76 is predicated on a 12x target PE multiple on 2018 EPS.

Long DAL outright.  If you need to be hedged, I would pair a DAL long vs. an equal weighted basket of AAL and UAL with a ratio of 2:1, and run a net long pair given my view that the industry is oversold on UAL’s actions.

Catalyst

1. 1Q18 RASM coming in at or above the high end of the guidance; recent data points suggest European corporate travel is very strong

2. Long only community comes back to space as domestic GDP accelerates / tax cuts work through economy

3. Warren Buffet adds to his holdings.  He just sold $3.3 billion of PSX stock.  Super bull case on DAL is Buffet pulls a BNSF and takes it private