By David Sterman
In recent decades, the airline industry has repeatedly burned investors -- as economic slowdowns or fuel price spikes wiped out industry profits. Many investors, including Warren Buffett, have suggested it is best to steer clear of this boom-and-bust industry.
Yet in recent years the entire airline industry has undertaken a radical overhaul. Debt loads have been pared, labor costs have fallen and the supply of available seats is much more closely aligned with demand. It's time that Buffett and others gave this industry a fresh look. Airlines stocks are now nicely profitable -- in good years and bad -- and their fast-rising shares have further upside ahead.
You can get a sense of the improved industry dynamics by poring over the financial statements of Delta Airlines
). I looked at this stock in the summer of 2011
, noting that shares looked stunningly cheap at just four times projected free cash flow. At that time I suggested shares looked poised to double in value, and that's just what happened (compared to a 20% rise for the S&P 500 in that time frame).
I took a fresh look at Delta's operating metrics and cash flow potential, and there's no reason for this stock to pause at $16. By the time this rally is over, shares may move up into the lower to mid $20s.
To figure out what this stock is truly worth, let's take a look at free cash flow, balance sheet trends and what Delta may do with its fast-improving capital structure. Back in 2011, I wrote that "the carrier generated $1.4 billion in free cash flow (in 2010) and should generate at least a similar amount in (2011)."
Let's take a look at what has actually transpired, along with forward projections.
Delta's Free Cash Flow
Free cash flow slumped in 2012 as Delta spent nearly $2 billion on capital spending to bolster the business, including the purchase of an oil refinery that will save Delta $300 million in annual jet fuel costs. The fact that Delta is expected to generate more than $2 billion in free cash flow next year is simply stunning, when you consider the carrier generated a cumulative $5 billion free cash flow deficit from 2004 through 2009.
After the economic slump of 2008, management promised to seek out cost savings under every rock -- and boy are they delivering. The lower cost structure means that even if global air travel slumps badly, Delta is still likely to generate positive free cash flow.
Even Buffett should like that.
Falling debt load
Despite that robust free cash flow, shareholders haven't benefited from any share buybacks or dividends. Instead, Delta has been pushing to steadily lower its debt load. Total debt stood at $17.2 billion at the end of 2009, fell to $12.7 billion by the end of 2012 and could reach $10 billion later this year. Once that figure has been reached, management expects to shift gears away from debt reduction and start returning excess cash flow to investors.
It's crucial to understand the roughly $7 billion drop in debt (from the end of 2009 to later this year) in the context of this stock's market value. Shares of Delta, as noted earlier, have doubled since the summer of 2011, adding a little less than $7 billion in market value. Paired with the larger drop in debt, that means Delta's enterprise value is even lower than it was back then.
Delta currently has around $9 billion in net debt (after backing out the company's $3.5 billion in cash and $1.6 billion in short-term debt from the current long-term debt figure). That adds up to an enterprise value of around $22.5 billion, though that figure should fall to just $21 billion by the end of the second or third quarter, as Delta pays down more debt. As Merrill Lynch's analysts note, the falling enterprise value means that "by nearly every valuation measure, Delta's stock price has never been less expensive."
The company's enterprise value is now less than 10 times its projected 2014 free cash flow, which equates to a free cash flow yield in excess of 10%. (Most companies in the S&P 500 have free cash flow yields below 5%).
Not just cost cuts
Delta's improving financial performance is not solely about expense reductions and debt pay downs. Delta's pricing strategies have also been remarkably impressive. In the past two years, the company has generated a 16% increase in revenue per average seat mile -- a key airline industry metric -- which leads the industry by a wide margin, according to Merrill Lynch.
Much of this gain has come from an increased emphasis on higher-paying corporate customers, though international expansion and higher baggage fees have also helped. Presumably, a firming global economy will give Delta -- and the whole industry -- even better pricing power.
In sum, the vast set of changes that Delta's management has made to this business model are not simply transitory and instead mark the "new normal" for a once-beleaguered company.
Risks to Consider: A big spike in oil prices remains as the biggest threat to this company and this industry.
Action to Take: Although Delta will likely earmark just a portion of its free cash flow in 2014 to buybacks and dividends to reduce debt further, look for more robust shareholder returns in subsequent years. Assuming free cash flow stays constant at $2.3 billion into 2015, the company could afford to pay out 80 cents a share in annual dividend. That's the equivalent of a 5% yield and equates to around $700 million in cash spending.
The remaining $1.6 billion in free cash flow could buy back around 100 million shares annually, which would shrink the share count by more than 10% each year. Few investors are talking about this right now, but look for this to become a much-discussed topic later this year once Delta hits its debt targets.
Looking at this stock purely on a price-to-earnings (P/E) basis, shares trade for around 5.5 times projected 2014 profits. Simply moving that multiple up to eight gets this stock up to $24 -- or 50% higher than current levels.
David Sterman does not personally hold positions in any securities mentioned in this article.
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