Scenarios That Can Move Delta’s Stock Price

The sharp decline in the global crude oil prices has suddenly put the US airline industry on the front burner. As jet fuel costs constitute nearly a third of an airline’s total operating expense, the 50% drop in oil prices over the last nine months has accelerated the bottom line of all the major US airlines. While the earnings of legacy carriers like American and United surged due to the fuel cost savings in 2014, Delta suffered hedging losses of $2.3 billion due to mark-to-market adjustments on its fuel hedges during the year. Consequently, the airline’s EBITDA fell significantly from 18.7% in 2013 to 15.3% in 2014 ^[1]. However, the stock price of the Atlanta-based airline rose by 10% in the last nine months driven by the changed perception for the airline industry. In this article, we will discuss three scenarios that could have a significant impact on Delta’s current valuation.

Our current price estimate for Delta stands at $48 per share, 5% ahead of its current market price.

See our complete analysis for Delta here

Base case: Gradual Oil Price Recovery

Since July of last year, crude oil prices have plunged from over a high of $110 per barrel to a low of $45 per barrel in January of this year, on the back of weak global demand, lead by the slow growth in the Chinese economy, and surplus oil production due to the rising tight oil production in the US.  In addition, the Organization of Petroleum Exporting Countries’ (OPEC’s) decision to maintain its current production rates further aggravated the demand-supply mismatch. While the decline has weighed heavily on the oil producing companies in the US, it has been profitable for most of the US airlines, except Delta. While the profits of all US airlines soared drastically in 2014, Delta’s net income (excluding special items) grew only 3% during the year, primarily due to the hedging losses incurred by the airline ^[1].

Over the last two months, the crude oil prices have reached the mark of $55 per barrel, showing signs of a revival given to the large cutbacks on production by all major oil companies. We currently expect oil prices (Brent) to average around $75 per barrel in this year and gradually increase to $85 per barrel over the next two years. Consequently, in our base case scenario, we forecast Delta’s fuel costs (expressed as a percentage of passenger revenue) to fall to 29% over the next two to three years as opposed to more than 33% in 2014. To avoid further hedging losses, Delta has significantly reduced its fuel hedging exposure for the last two quarters of 2015. Hence, we expect the airline’s profits to accelerate in the latter half of the year, resulting in notable profits for this fiscal year.

See our Base Case Scenario for Delta here

V-shaped Oil Price Recovery (-19%)

If we look at a more optimistic oil scenario, where we presume that the demand for crude oil will improve significantly, due to increased economic activity in China and concurrently, the tight oil production in the US will decline, there could be a possibility of a sharper, V-shaped recovery in crude oil prices. Moreover, if the OPEC decides to change its current stance and cut its production, we estimate the crude oil prices to reach over $120 per barrel by the end of our forecast period. In that case, we estimate Delta’s fuel costs for US operations to increase to 30% of its revenue by the end of our forecast period, as opposed to 27% assumed in our base case. Similarly, the airline’s international fuel costs will reach 41% of its revenue during the same period, versus 37% in our base case. As a result, the EBITDA margin of the airline will remain weak over the next two to three years, before reverting to its 2013 mark of 19% by the end of our forecast. The price estimate for Delta in this scenario would fall to $39 per share, a 19% downside to its stock price in our base case scenario.

See our analysis for V-shaped Oil Price Recovery for Delta here

Fig. 1 – Delta’s Fuel costs for US operations under V-shaped Oil Price Recovery scenario and Sustained Decline in Oil Prices scenario

Sustained Decline in Oil Prices (+14%)

Contrary to our V-shaped recovery scenario, if the demand for oil does not improve either because of a continued slowdown in the Chinese economy or due to the use of alternative fuels owing to technological advancements, the oil prices will take longer than expected to recover. Additionally, if the OPEC continues to operate at its current production levels, or alternatively, if it plans to increase its production rates to eliminate competition and increasing its market share, the global oil market will experience depressed oil prices for a prolonged period. If this scenario becomes a reality, we estimate Delta’s US fuel costs to drop to 25% and international costs to 34% by the end of our forecast, boosting the profits of the airline to new heights. In this case, the airline’s EBITDA margin will escalate to over 24% by the end of our forecast period. Driven by this, we arrive at a price estimate of $54 per share for Delta’s stock, an upside of 14% to our current price estimate for the airline.

See our analysis for Sustained Decline in Oil Prices for Delta here

Fig. 2 – Delta’s Fuel costs for International operations under V-shaped Oil Price Recovery scenario and Sustained Decline in Oil Prices scenario

Excessive Capacity Additions By Delta (-12%)

Delta, despite being a large network carrier, has been expanding its capacity at a rapid pace primarily to establish an international hub at Seattle to offer its services to the Asian markets. Also, the Atlanta-based airline intends to set up a hub at Shanghai to strengthen its presence in the Asian market. However, the rapid capacity expansion by smaller airlines like Alaska Air and low-cost carriers such as Southwest and JetBlue, has led to a surplus of seats in the market, creating pricing pressure for the legacy carriers, particularly Delta.  In addition, there is increased competition from Gulf airlines which is negatively impacting the airline’s business. To top it all, the strengthening of the US dollar is creating a drag on Delta’s profitability. Consequently, the airline has announced to cut back its international capacity by 3% by the end of 2015, particularly in Japan, Brazil, Africa, India, and the Middle East, the markets that have been worst hit by the currency fluctuations. Delta, the third largest airline by traffic, has decided to trim up to 15-20% of its services in these markets to improve its pricing power and long-term margins.

In our base case, we forecast Delta’s international market share to drop from 13.2% in 2014 to 12.4% in 2015 and remain stable going forward. Given the capacity pull backs indicated by the airline, we expect its occupancy rate to improve marginally to 85% and its passenger yields to reach $0.151 by the end of our forecast period. Now, we assume a scenario where, despite the increased competition and pricing pressure, Delta continues to aggressively add capacity in its quest to create a hub at Seattle. The carrier’s aim to enter the lucrative Asian market may trigger this scenario. While this will help Delta to expand its market share, it will weigh negatively on the profitability of its international operations. In this scenario, we assume the airline’s international capacity (measured by available seats miles) to increase to 105 billion, representing a market share of 13.7% in 2015 which will gradually rise to more than 14% by the end of our forecast period. However, this will lead to a dip in the airline’s operational efficiency measured by occupancy rate and passenger yields. We expect Delta’s international occupancy rate to fall to 80% from 84% in 2014 and its passenger yields to decline from 0.141 in 2014 to 0.132 by the end of our forecast period. As a result, our price estimate for Delta’s stock under this case stands at $42 per share, 12% below our current price estimate for the airline.

See our analysis on Excessive Capacity Additions for Delta here

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1. Delta Announces Operating Results for 2014, 11th Feb 2015, www.delta.com [↩] [↩]