Delta Earnings: Postpandemic Wanderlust and Pinched Capacity Offer a Rare Opportunity
Delta Earnings: Postpandemic Wanderlust and Pinched Capacity Offer a Rare Opportunity for Airlines
Analyst Note| by Brian BernardUpdated Apr 13, 2023
No-moat Delta reported passenger revenue 50% higher than the first quarter of 2019 on flight capacity essentially flat from that year (98.3%). However, the company's (and the industry's) operating costs have also swelled in the last three years, which suppressed profits in the quarter and disappointed investors who were expecting higher per-share earnings. We do not plan to change our $60 fair value estimate, and while we note that Delta's shares are undervalued, we don't believe the extraordinary tailwinds it is experiencing will persist indefinitely.
Delta's strong bookings for the busy summer season and an improving cost picture in the second half of 2023 bode well for the rest of the year: Delta is working off the tail end of massive disruptions to its employee base and operations stemming from the pandemic, including training thousands of new employees and having renegotiated numerous supplier contracts, and it plans to refurbish its midwestern airport hubs in coming months. As a result, its cost structure should improve as those investments are completed and demand for travel remains very high, which results in higher-than-usual ticket prices because of constrained capacity.
You will hear more about what Delta management calls this "constructive industry backdrop", which we would describe as a once-in-a-lifetime set of circumstances that we believe could provide airlines with a few years (but only a few!) of very strong results, as industrial hangovers from the COVID-19 pandemic collectively constrain airline capacity even as travelers continue to return to the skies in droves to fulfill pent-up travel desires.
Business Strategy and Outlook| by Brian BernardUpdated Apr 13, 2023
We believe Delta Air Lines is the highest-quality legacy carrier because it has been able to attract high-yielding business travelers through its product segmentation and credit card partnerships, primarily with American Express. Delta’s five-cabin segmentation strategy allows high-spending travelers to purchase premium options when they are able to. Frequently, business travelers use miles from a cobranded credit card to upgrade flights when their company is unwilling to pay a premium price. American Express pays top dollar for the miles given to these business travelers, as Delta-cobranded cards alone account for about a fifth of American Express’ loan book. We’re confident that Delta can continue expanding this higher-margin business.
In the leisure market, we expect Delta will continue to be pressured by low-cost carriers. While we believe its basic economy offering effectively serves the leisure market, we don’t expect the firm to thrive in this segment. We expect a leisure-led recovery in commercial aviation, reflecting customers' increased willingness to visit friends and family and vacation in a pandemic relative to business travel.
We expect that Delta will continue to target high-yielding business travelers, though we anticipate that the business travel market will remain difficult for the time being. Delta’s frequent flyer program consistently generates more loyalty revenue per dollar of lower-margin passenger revenue, which we think is indicative that the airline is generating substantial engagement with its platform.
The COVID-19 pandemic presented airlines with the sharpest demand shock in history, and much of our projections are based on our assumptions around how the long-term effects of the pandemic affect society. We're expecting a full recovery in capacity and an 80%-90% recovery in business travel that subsequently grows at GDP levels over the medium term. We think that Delta is well positioned to withstand the pandemic, but its strategy of extracting value from business travelers will be challenging in a lower-fare environment that focuses on serving leisure travel.
Economic Moat| by Brian BernardUpdated Apr 13, 2023
We do not believe that Delta has earned an economic moat, but we think U.S.-based airlines have structurally improved their business model. Airlines have traditionally been an industry where a no-moat rating is almost too generous, with a history of value destruction as measured by subpar returns on capital. IATA, an international industry group, estimates that industrywide returns on invested capital have not breached 8% in the past 15 years. In our view, structural factors make it difficult for airlines to generate excess returns: a mostly undifferentiated product, a tendency for irrational competition, substantial operating leverage, and a tendency to employ financial leverage that exacerbates booms and busts. We believe that the U.S.-based major airlines have structurally improved their business model through consolidation that reduces, but not eliminates, the potential for irrational competition and through attractive partnerships with banks on their frequent flyer programs. We do not think that these improvements are enough to dig a moat for three major reasons. First, airline operations remain large and capital-intensive enough that we don’t expect substantial excess returns over the cycle. Second, airlines remain highly sensitive to unpredictable events that can quickly destroy value. Third, airlines have already raised quite a bit of debt capital to survive the COVID-19 pandemic, and we think the threat of company failure and major value destruction is high enough that it precludes any carrier from having a moat.
Airlines have historically sold commodity goods and operated in a highly competitive market, so participants in this market have traditionally been unable to control prices or costs. Typically, the primary moat source for highly competitive companies with commodity products is the cost advantage. Durable cost advantages for industry participants are elusive because low-cost and ultra-low-cost carriers’ business model is predicated on continuously driving down yields to attract customers with lower fares. Delta has historically had comparably similar costs per available seat mile excluding fuel costs to peer legacies. Much of the differences in legacy airlines’ cost per available seat mile can be explained through small differences in items such as depreciation and landing fees, which we don’t think constitute an economic advantage.
Delta has historically captured a premium yield relative to peers, due to its focus on business travel and premium products, and has received the highest yield among legacy airlines for the past nine years. We believe this is not evidence of a major intangible asset but more due to a higher mix of higher-yielding business travelers relative to peers. As business travel is highly cyclical, we expect that this advantage is difficult to maintain in a distressed economy.
We think that frequent flyer programs are essentially a capital-light business with the potential for intangible assets and switching costs attached to a capital-intensive, highly competitive airline business. Intangible assets would come from the long-standing and contract-based relationships that airlines have with credit card companies to sell frequent flyer miles. Switching costs would come from being the sole provider of a currency—frequent flyer miles—that credit cardholders find valuable. The switching costs would specifically be due to credit card companies facing difficulties in providing their customers with rewards cardholders want. At this time, we do not have enough certainty that the core airline business has escaped its long-running tendency to destroy value in normal times, and we do not have enough certainty in the durability of returns from the capital-light frequent flyer program to grant any airline a moat.
Fundamentally, the business of frequent flyer programs can be simplified to airlines selling miles to banks. Airlines recognize revenue from selling miles to credit card companies on the frequent flyer programs in four ways. First, through marketing revenue, which represents the difference between the selling price of the mile and the redeemable value of the mile. We view this revenue as almost entirely incremental to the airlines and think that a 90% margin on this revenue is reasonable. Second, there are nontravel awards (which generally account for a small fraction of awards redeemed) such as baggage, priority boarding, and lounge access, which we assume a 70% margin on. Third, there are travel-related awards, which we conservatively assume have a similar margin to the rest of the passenger revenue, although we have reason to believe that a material proportion of these awards are used to upgrade existing travel, which would be a higher-margin transaction than new travel. Finally, there is breakage revenue from miles that are not redeemed. We estimate that the loyalty programs have operating margins of 35%-45% and constitute a significant proportion of operating income for the airlines.
The economics on this program are quite attractive, and one might wonder why banks would be willing to pay 2-3 times the redeemable value of a mile and how durable these attractive agreements are. We think the Delta-American Express cobranded card is a great example of the value airlines provide to cardholders. American Express has built its brand around serving the higher-spending business traveler, and Delta’s five-cabin segmentation strategy revolves around offering premium products to higher-spending customers. These cobranded cards allow business travelers to rack up frequent flyer points, save on baggage fees, receive priority boarding, gain access to airport lounges, and receive complimentary upgrades on flights that don't have full first-class bookings. Providing additional comforts to travelers is proving to be a very popular currency among business travelers. The cobranded Delta cards represented approximately 8% of American Express’ billings and approximately 22% of the firm’s loan portfolio in 2019. Delta’s loyalty revenue was roughly 20% of American Express’ cardmember reward and business development expense in 2019, which may seem like a hefty price, but American Express was eager to extend the relationship until 2029. Delta cobranded cards were noted as a growth driver in American Express’ 10-K filings of 2015-19, and Delta awarded considerably more miles than it redeemed since it began disclosing mileage redemptions in 2017, which we believe is indicative that it is still growing fairly quickly. Delta generates the highest percentage of high-margin revenue per dollar of lower-margin passenger revenue relative to peers, which we think makes the program the most efficient.
In terms of the durability of these businesses, the driving forces behind mileage sales are new card openings and spending on cards. While Morningstar anticipates continued growth in credit card spending and anticipates that fees to merchants as a proportion of credit card spending will remain reasonably constant, benefits from new card openings are not continuous. We view this as a solid business going forward, and while we aren’t anticipating 2015 margins to return anytime soon, we think that U.S. airlines will continue earning the lion’s share of global airline profits.
The coronavirus crisis has presented the industry with its sternest test in history. Peak-year to trough-year capacity declines of midsingle digits after 9/11 and the 2009 financial crisis pale in comparison with the roughly 50% industrywide capacity declines seen in 2020. Previous recessions invited consolidation, allowing remaining firms to continue growing, but we do not anticipate further consolidation to be possible. While we think the COVID-19 pandemic will not change the structural improvements to the U.S. airlines, we do think this cyclical shock highlights the lack of a moat in this industry.
We think the longest-lasting effects of COVID-19 on the airlines will be increased leverage and equity dilution at low prices. To survive near-term losses, the airlines have raised substantial capital to fund unprofitable operations. We think that this leverage is more likely than not to remain on the firms’ balance sheets for the foreseeable future because airlines do not generate enough free cash flow to take this kind of debt off the balance sheet in short order. As airlines have balance sheets that are as large as they can currently manage, we think that capital markets would be less amenable to airlines going forward, which would increase the chance of firm failure in the event of an additional unforeseen black swan event or a protracted lockdown. We think that this risk is material enough that we would hesitate to give any airline a narrow or wide moat rating for the time being.
Fair Value and Profit Drivers| by Brian BernardUpdated Apr 13, 2023
After reviewing Delta's first-quarter 2023 financial results, we've maintained our $60 per share fair value estimate. The primary drivers of our valuation are the pace of the recovery in air traffic and our midcycle operating margin.
Delta expects revenue growth of 15%-20% year over year in 2023 (excluding third-party refinery sales) with a 10%-12% operating margin. In 2024, the firm sees moderating top-line growth (GDP-plus) with a 13%-15% operating margin. Our outlook is more cautious on long-term yield potential, among other factors, but we nevertheless think an approximate 14% operating margin is a good estimate of a normalized midcycle operating margin.
Airlines faced the worst operating environment in history in 2020 due to the COVID-19 pandemic and dramatically cut capacity to respond to steep drops in demand. Domestic leisure travel demand has recovered considerably with the reopened U.S. economy. Airlines have not fully recovered yet, as business travel and international travel remain below 2019 levels. We think Delta can return to 2019 levels of capacity in 2023. We expect 2027 revenue passenger miles will be approximately 11% higher than 2019.
Over the near term, we're expecting a healthy domestic leisure travel market, more business travel as workers return to offices, and a strengthening international travel market as COVID-19 restrictions abate. We anticipate 2023 capacity will be about even with 2019 levels, load factors will be 84%, and yields will begin to moderate after significant gains in fiscal 2022.
Our midcycle operating margin for Delta is approximately 14%, roughly in line with the 2016-19 average. We believe margin expansion from 2019 levels (near 12%) is reasonable because we expect high-margin loyalty marketing income will continue to grow, as loyalty revenue continues to rise from increased spending on Delta cobranded cards. Also, voluntary retirement packages during the pandemic have improved the company's underlying cost structure.
We expect capital expenditure will be about $5.5 billion in 2023 and will average around $5.0 billion per year over our forecast period. We think this elevated level of capital expenditure is reasonable relative to historical levels as Delta has orders to replace much of its fleet and deferred capital expenditures during the pandemic.
We think an above-average cost of equity and cost of debt are reasonable for this airline, which leads us to an 9.2% weighted average cost of capital.
Risk and Uncertainty| by Brian BernardUpdated Apr 13, 2023
Our Morningstar Uncertainty Rating for Delta is High. We view geopolitical risks on each node on its network, commodity price risk from the oil market, risk of irrational competition, and general cyclical risk as the primary sources of uncertainty for Delta.
Fuel is airlines' second-largest cost, and we expect it to be a major variable cost for airlines for the foreseeable future. Rapidly increasing oil prices could make air travel significantly more expensive in real terms, which may damp air travel demand. Delta operates a fleet that is on the older end of peers and is particularly exposed to this risk as older aircraft are less fuel-efficient.
Airlines have a long history of irrational competition due to low entry barriers and high exit barriers in the industry and a price-sensitive customer. Low-cost and ultra-low-cost carriers have tendencies to enter markets and drive returns down for all participants due to an excess of supply for a somewhat fixed pool of demand. We think that the wave of consolidation in U.S. airlines after the 2009 financial crisis reduces but does not eliminate the potential for irrational competition.
Air travel is generally a discretionary good that closely tracks the gross domestic product. Recessionary economic contractions reduce travel demand, which is a risk to airline investors. At this time, we do not see a way for airlines to escape cyclicality.
We see some environmental, social, and governance risks for Delta, largely a function of the greenhouse gas emissions from the company's operations. If carbon taxes are enacted, airlines would likely pass the costs on to consumers, which we anticipate would reduce aggregate travel demand. At this point, ESG risk does not affect our fair value estimate or our scenario analysis.
Capital Allocation| by Brian BernardUpdated Apr 13, 2023
We award Delta an Exemplary Capital Allocation Rating, based on a weak balance sheet rating, an exceptional investments rating, and an appropriate shareholder distribution rating.
Delta's balance sheet has ballooned since the beginning of the COVID-19 pandemic, increasing debt by about $18.5 billion in 2020. As of the first quarter of 2022, about $25.6 billion of debt and $10.0 billion of cash remained on the balance sheet. Although Delta has a bloated balance sheet, it has a substantial amount of excess cash raised during the pandemic. We anticipate that Delta, like other airlines, will have one capital allocation option after the pandemic: It will need to use excess cash raised during the pandemic and any free cash flow to reduce leverage.
The primary driver of our Exemplary capital allocation rating is the exceptional investments rating. We're positive on management’s capitalization on frequent flyer programs, which have attractive economics. Legacy airlines are inherently more exposed to business travel than to leisure travel, and we think Delta has been the best airline at capitalizing on its access to these high-spending business travelers through its frequent flyer program and extensive cabin segmentation. Delta’s cobranded offering continues to generate more high-margin loyalty revenue per dollar of lower-margin passenger revenue. We believe this is due to management’s ability to modify airline operations and selling practices to structurally improve margins, which we view as outcompeting peers and thus deserving of an Exemplary rating. In no-moat industries like airlines, we think that stewardship matters quite a bit in determining the overall quality of a firm, and we think that Delta has become a best-in-class legacy airline operator.
We think Delta has appropriate shareholder distributions. The firm maintained a dividend and a share-repurchase program from 2013 through early 2020 and historically delivered most of its free cash flow back to shareholders, but the firm suspended its dividend in the wake of the COVID-19 pandemic. Delta has raised capital to survive 2020, but we think that its strong margins, which we think are a function of strong management, would allow the firm to survive a normal recession without raising capital. Given the highly uncertain operating environment, we don’t think that airline investors should count on shareholder remuneration returning for at least the next several years.
Ed Bastian has worked with the firm for over a decade and has been CEO since 2016. We appreciate that Delta has stuck to its aircraft acquisition strategy, mainly purchasing cheaper used aircraft but also acquiring new planes, such as the A220, at bargains. We believe these developments have created shareholder value. In May 2021, Delta announced that Dan Janki, the former CEO of GE Power, would fill the vacant CFO role. This development does not change our long-term view of the company.