Airlines stock are under pressure since last week over the concerns around pricing and capacity discipline. Investors were disappointed that Southwest Airlines (LUV, Financial) raised its 2015 capacity growth to 8% from 7%. They were also worried because of American Airlines (AAL, Financial) comments that it will compete aggressively on price with low cost carriers to defend market share.
Goldman Sachs (GS, Financial) analyst Tom Kim thinks this correction is a buying opportunity for investors and airline stock offers compelling risk reward. In a recent investor note, he wrote:
"Thus far, domestic pricing and capacity behavior has been rational. There are certain pockets where capacity has been growing disproportionately, such as Dallas and Seattle, but overall ASM (+3.2%) have been increasing largely in-line with RPM (+2.9%) ytd.
The domestic market has fueled the multi-year airline rally, as rational pricing in a favorable supply/demand environment drove topline growth. Following years of consolidation, supply discipline, de-leveraging, and cost take-out execution, industry participants began to suggest that ‘this time is different’. However, recent events reflect that the industry remains competitive and we remain in the “show me” camp.
Following Wednesday’s sell-off our coverage group now trades at 8.8x on P/E, representing a 10% discount to the five-year average. While we expect concerns around pricing to continue to pressure shares, current valuations should provide support. The industry’s earnings power, high free cash flows, reduced financial leverage and capital returns offer a compelling risk/reward.”
I believe investors should consider going long on Airlines stock at current levels. In particular, I find Delta Airlines (DAL, Financial) risk reward compelling.
Delta is one of the cheapest S&P 500 stock trading at a forward PE of just 8 times. Delta is also one of the best airlines in terms of operational excellence. In 2014, the company had 95 days of no mainline cancellations, a completion factor of 99.8% and an on-time rate of 85%. This excellent operational performance translates into revenue premium as customers are willing to pay for high quality services.
The company's operational excellence coupled with the falling crude price is leading to improved profitability. Delta is judicially using its cash flow from improved profitability. The company has paid down $2.1 billion in debt last year and its net debt level at year end was $7.3 billion. This translates in $200 million of annual interest savings. In addition to bringing down its debt levels, the company also repurchased $1.35 billion in stocks and paid out $251 million in dividends last year.
Going forward, the company expects a significant increase in pre-tax profit in 2015 from fuel cost savings and the benefits of initiatives it is taking to increase its top line. The company plans to bring down its debt levels to $6 billion by the end of 2016 and $4 billion by 2017. Delta has earlier announced its plans to significantly accelerate its capital returns and spend a minimum of $1.5 billion in dividends and buy backs in 2015. Now it seems like these targets could be met by the middle of this year, and the company’s actual capital return through buybacks and dividends in 2015 will be much higher.
Delta's shares are trading at 10.25 times and 8.23 times FY2015 and FY2016 consensus EPS estimates, respectively. Its forward annual dividend yield is 0.80%. Out of 18 analysts covering the company 16 are bullish and have buy recommendation, and two have hold ratings. Imperial Capital analyst Bob McAdoo believe that the company could trade at a multiple in line with S&P 500 Industrials average. In a research note sent after the company's investor day presentation last year, he commented:
“Investor Day commentary outlines long-term operating goals and DAL’s belief, with which we concur, that the company should trade at multiples similar to other S&P Industrials. Within its Investor Day presentation on 12/11/14, Delta outlined its long-term operating and balance sheet goals. The company is targeting annual EPS growth of between 10% and 15%, consistent with consensus growth of 12% for other S&P 500 industrial companies. Operating margins should continue to be 11-14%, though we believe lower fuel prices could drive significantly higher operating margins in 2015.”
Given the company's operational excellence, history of returning cash to shareholders, fuel cost tailwinds and attractive valuation, I recommend buying the stock.
