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Investment Overview for Delta Air Lines (NYSE:DAL)
- Recovery In Crude Oil Prices
Over the last two years, global crude oil prices have plummeted more than 50%, falling from over $110 per barrel in July 2014, to less than $40 per barrel in March 2016. This sharp drop in crude oil prices helped large US airlines such as Delta Air Lines, as jet fuel costs constitute more than one-third of an airline's total operating expenses. A notable fall in these costs results in huge cost savings for the airline, which expanded Delta's margins significantly.
However, in the fourth quarter of 2016, the crude oil prices have rebounded to about $55 per barrel from multi-year lows of $30 per barrel in the first quarter of 2016. This recovery is primarily driven by the OPEC countries' decision to restrict their combined oil output to 32.5 million barrels per day, a potential reduction of 1.2 MBPD (million barrels per day) compared to the output in August. While the current oil prices are still significantly lower compared to 2014, the cost advantage enjoyed by Delta over the last few quarters is diminishing. As a result, the airline expects its fuel costs to go up in the future. Further, the recovery in crude oil prices is likely to create a pressure on its margins.
- Downward Revision Of Capacity
The strengthening of the U.S. dollar against other currencies has made US travel expensive for international passengers. As Delta has a significant presence in the international markets (27% of total revenue), it has witnessed a sharp drop in its unit revenue most of the year. However, towards the end of the year these headwinds started dissipating. This is attributable to the capacity restriction the company undertook and improvement in close-in yields around the holiday period. Consequently, Delta expects its unit revenues to rise in the 0%-2% range in Q1, 2017.
Going forward, the company intends to continue restricting or even cutting capacity, if needed, in order to see growth in its unit revenues and operating margins. The system-wide capacity is likely to stay flat in the first quarter of 2017, to facilitate growth in unit revenues.
- Rising Wages Impact Margins
The company incurred additional costs of 10.6% y-o-y in the fourth quarter. Of the total increase, roughly 8 percentage points is attributable to the impact of the new pilot contract, which came into effect retroactively from 1st January 2016, totaling $475 million of expense, of which $380 million relates to the first three quarters of the year 2016. Besides, the increases in wages and salaries, aircraft maintenance, contracted services and rents, and landing fees drove the expenses higher. Consequently, Delta's operating margins came down by over 7 percentage points, resulting in a decline in earnings per share in the quarter.
Going forward, these costs are expected to keep rising as crude oil prices go up, and the effect of the new pilot contracts is felt on the bottom line. Accordingly, the operating margin in the first quarter will only be slightly better than that seen in Q4'16. Furthermore, Delta's management mentioned that its priority is to keep the capacity growth in check until it is able to reach previous levels of operating margins (17%-19%).
- Returning Value To Shareholders
The increased cash flows from lower fuel costs over the last few quarters have enabled Delta to return higher value to its stakeholders in the form of dividends and share buybacks. The airline reinstated its dividends in 2013 and has been increasing the quarterly dividends by almost 50% annually. It currently pays a quarterly dividend of $0.135 per share. Apart from this, the legacy carrier also has an authorized share repurchase plan of $5 billion to be completed by 2017. The airline has repurchased its common stock worth $1.8 billion in the first half of 2016. Further, it is enhancing its capital structure by repaying its long term debt obligations. In the first half of the year, the airline paid off $1.1 billion in long term debt. This will help the airline improve its return on invested capital for the full year.
However, the rising fuel prices and wages are expected to impact the company's cash flows negatively going forward.
Below are key drivers of Delta Air Lines value that present opportunities for upside or downside to the current Trefis price estimate.
Delta - US
Fuel Expense % Revenue for Delta's US flights: Fuel expense is the largest operating expense incurred by an airline. For Delta, it has averaged around 35% (as a percentage of its revenue) over the last 7-8 years. It stood at 37% of its US revenue in 2014. However, due to plummeting crude oil prices since mid-2014, fuel expenses have declined substantially for the airline. Fuel expenses as a percent of revenue fell to close to 20% in 2015 due to the depressed oil prices.
Since the outlook for oil prices is weak, we expect the fuel costs to decline in the near term, before recovering to their historic levels by the end of our forecast period. If, however, crude oil prices fall further, and fuel expenses drop to 30% instead of the current forecast of 35% by the end of the Trefis forecast period, then there could be a potential upside of around 20% to the Trefis price estimate for Delta's stock.
US Passenger Yield: Delta’s US Passenger Yield increased from $0.119 in 2009 to $0.172 in 2014. However, due to increased competition in the domestic market, the airline experienced pricing pressure which led to a sharp fall in its passenger yield in 2015. Delta's passenger yield declined to $0.170 during the year. However, we expect the competition to ease out causing the airline's passenger yield to grow steadily to $0.186 by the end of the Trefis forecast period. If, however, the carrier's passenger yield rises less than anticipated to grow to only $0.159, then there could be a potential downside of more than 7% to the Trefis price estimate of Delta's stock.
Delta Air Lines is one of the largest passenger airlines in the world operating an extensive domestic and international network which spans the Americas, Europe, Asia-Pacific, Africa, the Middle East, the Caribbean, and Australia. Delta and its subsidiaries operate over 4,000 flights every day. The carrier is headquartered in Atlanta.
Delta's route network is centered around the hub system it operates at airports in Amsterdam, Atlanta, Cincinnati, Detroit, Memphis, Minneapolis-St. Paul, New York-JFK, Paris-Charles de Gaulle, Salt Lake City, and Tokyo-Narita. Each of these hub operations includes flights that gather and distribute traffic from markets in the geographic region surrounding the hub, to domestic and international cities, and to other hubs. Delta's network is supported by a fleet of aircraft that is varied in terms of size and capabilities, giving it the flexibility to meet corporate demands for travel.
It also has alliances with other domestic and foreign airlines to aid its network. These alliances include code sharing, reciprocal frequent flier program benefits, joint promotions, and common use of airport gates among others. Delta is also a part of SkyTeam which is one of the three major global airline alliances.
Extensive service network
Delta has one of the largest service networks among other US airlines. A large service network enables the carrier to attract corporate travelers to its loyalty program which supports higher yields as many corporate travelers opt for first class travel.
International equity investments
Delta has made equity investments in Virgin Australia, Virgin Atlantic, Aeromexico, GOL, and China Eastern. These investments increase the carrier's presence in important international air travel markets, boosting its passenger traffic and revenues.
Oil prices significantly impact bottom line
Fuel expenses constitute the single largest cost head for airlines, making them vulnerable to hikes in crude oil prices. For Delta, fuel costs constitute around a third of its total operating expense. To reduce vulnerability to fuel price volatility, Delta engages in fuel price hedging.
Demand for flights is related to global economic growth
Demand for flights is highly correlated to the global economic growth. Thus, a decline in economic growth, or recession, reduces demand for flights, impacting passenger traffic for airlines. On the other hand, steady growth in the global and U.S. economy, grows demand for air travel, allowing airlines to raise their air fares, occupancy rates, and profits.
Focus on ancillary revenue
Many airlines, including Delta, are figuring out ways to grow their top lines through ancillary heads such as baggage fees, access to on-board WiFi/food/drinks, etc. Accordingly, airlines are investing to enhance their product offerings that include in-flight WiFi and other entertainment options, improved lounge facilities, and extra legroom seats.
According to an Amadeus/IdeaWorks study, North American airlines collectively produce one of the largest stream of ancillary revenues compared to other regions. A majority of the increase is attributable to stronger merchandising efforts by the carriers, as well as the addition of more à la carte services for sale.
Growing preference for low-cost carrier model
During the past decade, low cost carriers such as Southwest and JetBlue have gained significant market share in the U.S. Looking ahead, we figure these low cost carriers will likely continue to grow their market share, as their lower fares attract passenger traffic.
Consolidation in the industry has helped raise profits of all airlines
The U.S. airline industry has seen many mergers and acquisitions in the last decade, including the five big combinations of US Airways and America West, Delta and Northwest, United and Continental, Southwest and AirTran, and American and US Airways.
A more consolidated industry has worked to improve profits of all airlines. Fewer players in the market has made it easier for the remaining airlines to add capacity with restraint. Prior to this consolidation in the airline industry, individual airlines were adding capacity at higher rates in an attempt to grow their market shares. This rapid capacity addition resulted in an oversupply of seats, reducing margin and profits of all carriers.
Going forward, we believe as long as airlines add capacity with discipline, the industry should remain profitable.
How Does Trefis Modelling Work?
How do we get the historical numbers for this chart?
Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.
Who came up with the Trefis forecast for future years?
The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.
How does my dragging the trendline on the chart impact the stock price?
- We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
- We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.
See more on: DCF Methodology
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