James M. Higgins, CFA / Vaughn Cordle, CFA
Delta's (DAL) strategic initiatives and advantages appear undervalued. Although the year-to-date performance has been the best among its peers, Delta's shares have underperformed their most relevant competitors' (United (UAL), US Airways (LCC) and Alaska (ALK)) over longer time frames, as the following table illustrates.
Moreover, comparing Delta's valuation based on its trailing 2012 results to its two solvent domestic legacy network carrier competitors, LCC and UAL, further illustrates the extent to which investors do not appear to expect relatively strong future earnings gains from Delta.
As the following table shows, DAL shares are more expensive than LCC's on a price/earnings basis, but are less expensive for adjusted (to capitalize off-balance sheet operating leases) enterprise value metrics. Relative to UAL, which has suffered from merger consolidation hiccups and labor issues during contract negotiations, Delta is much cheaper on a P/E basis and effectively tied on AEV measures.
AEV is adjusted (to capitalize operating leases)/EBITDAR is earnings before interest, taxes, depreciation and amortization and aircraft rentals.
In our estimation, DAL's valuation reflects little expectation of future earnings gains that we forecast from three major strategic initiatives: 1) Fuel savings from the Trainer refinery purchase, 2) small aircraft fleet rationalization, and 3) the purchase of the 49% equity stake in Virgin Atlantic Airways.
Delta reduces jet fuel refining margins to save $300 million a year
DAL estimates that the Trainer, a PA refinery, purchased from ConocoPhillips in June of 2012, will save the company about $300 million annually, mostly by reducing jet fuel refining margins.
- An estimated 2.6 billion gallons of fuel is consumed each year by Delta's domestic operations, so the company needs to take only about 4.5% out of that refining margin to reach that $300 million goal. Since Delta's refining margin has averaged about 25% of raw fuel costs over the past year, the 4.5% reduction in jet fuel expense from it owning the refinery appears to us to be a quite reasonable expectation.
- There is, moreover, an upside to Delta's profitability from Trainer if the refinery is able to gain access to the Bakken basin crude oil inputs rather than the more expensive North Sea Brent crude that the refinery currently uses. The current Brent price premium over West Texas Intermediate is over $21 per barrel, or more than 15% of the current jet fuel prices.
- One other way to look at the refinery purchase as benefiting Delta is that the expected annual fuel cost savings from buying the refinery for a net $250 million (after Commonwealth of Pennsylvania incentives) would require a $2.5 billion investment in 60 new narrow-body aircraft. Stated differently, the fuel savings from the refinery allows Delta to maximize the use of its current fleet of older and less fuel-efficient aircraft.
Small aircraft fleet rationalization reduces fuel costs and delays
Delta plans to eliminate about 200 50-seat regional jets (RJs) that are flown largely by its regional partners and replace them on a capacityneutral basis with, largely, Boeing B-717-200s to be leased and subleased from Southwest Airlines. Southwest has determined that the 115-seat aircraft do not fit its strategic goal of maintaining a common fleet type, but those aircraft should enable Delta to better serve relatively thin markets from its numerous domestic hubs.
Replacing older, fuel-inefficient 50-seat RJs with higher-capacity narrow-body mainline aircraft will lower unit costs and reduce flight times. It will also potentially improve revenue generation, which in part is due to the use of an improved product that also includes domestic first-class seating.
In the year ending February 2013, 32% of Delta's system-wide flights were flown on 50-seat aircraft. That represented 5% of Delta's total ASMs and 20% of the block hours flown. Given the 65 additional seats in the B-717 aircraft, and when adjusted for the average 1.47 hour flight time of the 50-seat aircraft, Ionosphere estimates that per-seat fuel costs for the B717 will be 20% lower than for the current 50-seat aircraft operated by Delta's regional partners.
At $3.2 per gallon, this savings works out to $9 in fuel savings per seat or $12 per passenger given a 75% load factor. The implied ~$280 million in annual fuel savings represents 2.3% of Delta's $12.3 billion in total fuel costs last year.
If the small jet fleet rationalizing takes place along the lines we suggest, there will be major schedule and regional partner implications as the number of flights on the former 50-seat routes would be reduced by 57%. Since 32% of Delta's system-wide flights are flown using the 50-seat aircraft, the total number of flights would be reduced by 18%. Fewer flights into and out of major delay-prone (airport) hubs reduce air and ground block hour times, which in turn lower Delta's operating costs.
Refinery purchase and small aircraft replacement strategy worth $600 million
Ionosphere also estimates that, looking forward to 2015 when the fleet restructuring is slated for completion, Delta will save $400 to $450 million in operating expenses at fuel prices seen over the past year, even when including the approximately 17% increase in mainline pilot wages recently negotiated as part of an amended contract that paved the way for the fleet changes. Not included in that estimate, however, are the incremental revenues we would expect Delta to generate from having first class and premium economy seats available to sell on the new fleet.
After the impact of profit sharing is accounted for, we estimate these two strategic initiatives will add $575 to $625 million to Delta's pre-tax earnings, and $0.70 to 0.75 to pretax EPS. The after-tax EPS - assuming Delta must begin accruing for taxes at some point over this time frame to 2015 - is $0.40 to 0.45. That pretax gain would represent about 40% of DAL's 2012 EPS estimate, and would be unique to Delta among its airline peers.
At an earnings multiple of six, this unique earnings advantage adds $4.00 to 4.50 to DAL's equity value, or about 30% of the current stock price. Again, those estimates do not include the benefits of enhanced revenue generation from fleet restructuring, which we cannot currently estimate from the available information.
Delta buys Virgin Atlantic stake and its London slots at a discount
Finally, among Delta's value additive strategic initiatives is the recently announced agreement to buy a 49% stake in privately held Virgin Atlantic (currently owned by Singapore Airlines), the number two player in London's heavily restricted Heathrow Airport (LHR). The $360 million price tag for that stake is a steep discount on the $966 million Singapore paid in 2000, reflecting increased competition at Heathrow and likely greater investor concerns about the risks surrounding airline valuations.
Heathrow is the single most important business travel airport in the world. As seen in the following table, Delta significantly trails its large US competitors, American and United, in trans-Atlantic service to Heathrow, because of its inferior slot and facility position relative to the other two. However, when paired with Virgin, that combined entity has a greater number of long-haul flights out of Heathrow.
When the three global alliances' Heathrow shares are compared, Delta and its Skyteam partners still fall behind their closest competitor, United/Star, and suffer much more when pitted against service offered by American/oneworld, which will include US Airways once it leaves Star and joins oneworld as a result of the recently announced merger with American, but that gap will shrink.
Delta's plus Virgin's own service in the key trans-Atlantic markets will exceed that of either AMR or United alone and narrow the gap at the Delta/Virgin/Skyteam level to 73% of that for United/Star (up from 30%) and to 37% of that for American/oneworld, from 15%.
In all long-haul markets from Heathrow, adding to trans-Atlantic routes service to Asia, South America and the Caribbean, Delta/Virgin/Skyteam would offer 73% of United/Star's service (versus 28% for Delta/Skyteam alone) and 34% of American/oneworld, up from 13% without Virgin. A key benefit of Delta's enhanced US to LHR service will be its ability to win more corporate contract business than is currently the case.
Although too early to fully quantify this strategic initiative, our initial take is that Delta's investment in Virgin Atlantic will give it enough incremental share of the lucrative London-Heathrow market to generate an attractive return relative to the comparatively weak position Delta and Skyteam currently hold.
Smart strategies and aggressive initiatives drive future earnings
In summary, we believe Delta has systematically gained cost and revenue advantages over its competitors via smart strategies and aggressive initiatives that are difficult to replicate. In our view, the stock's performance and current valuation do not reflect those potential advantages and, therefore, these advantages represent a longer-term share price appreciation potential that is unusually favorable.