(Published by Nicholas McCullum on May 26)
Warren Buffett (Trades, Portfolio) shocked the investing world last November when he announced significant positions in the four major U.S. airlines.
Why was this shocking?
Well, the airline industry is notoriously cyclical. Many, many airline businesses have gone bankrupt when consumers cut their traveling budgets during recessions.
This is in sharp contrast to the rest of Buffett’s investment portfolio.
The "Oracle of Omaha" typically invests in high-quality, recession-resistant businesses with durable and defensible competitive advantages. In general, Buffett’s stocks are purchased with downside protection in mind.
Because of the unfavorable economics of owning airlines, Buffett has criticized this industry in the past:
“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”Â
Later on in his career, Buffett had even harsher things to say about the airline industry:
"Investors have poured their money into airlines and airline manufacturers for 100 years with terrible results. It’s been a death trap for investors.”Â
With that in mind, something must have changed his perception of the industry since then.
He is clearly bullish on the industry, with stakes of between $2 billion and $2.5 billion invested in the big four U.S. airlines.
Delta Air Lines Inc. (DAL, Financial) is Buffett’s second-largest airline holding behind Southwest Airlines Co. (LUV, Financial).
Business overview and recent financial performance
Delta Air Lines is one of the big four U.S. airlines, along with:
- Southwest Airlines
- United Continental Holdings Inc.Ă‚ (UAL, Financial)
- American Airlines Group Inc.Ă‚ (AAL, Financial)
Delta was founded in 1924 and began operations in 1929. Since then, the company has grown to a market capitalization of $37.3 billion. Delta is currently headquartered in Atlanta, Georgia.
Delta’s financial performance in recent years has been strong. The company has seen consecutive increases in pretax profit and capital returns to shareholders while simultaneously reducing its total adjusted net debt and unfunded pension liabilities.
Source: Delta Air Lines Presentation at the 2017 JP Morgan Aviation, Transportation and Industrials Conference, slide 4
2017 is set to be a transition year for the airline.
Margins are anticipated to be under pressure as revenue per available seat mile (RASM) is expected to decline slightly in the first half of the year. The back half of the year is expected to show margin expansion as Delta works toward its long-term goal of 17% to 19% operating margins.
Source: Delta Air Lines Presentation at the 2017 JP Morgan Aviation, Transportation and Industrials Conference, slide 5
Growth prospects
Delta has a number of potential headwinds to drive its near-term growth.
First of all, the company’s revenues have been under pressure in recent years as low oil prices have led the broader airline industry to reduce ticket prices – sometimes in excess of the cost savings provided by low oil.
As oil prices recover, Delta will be able to raise its ticket prices accordingly. The company notes the lag between rising fuel prices and revenue recapture has historically been roughly two quarters.
Source: Delta Air Lines Presentation at the 2017 JP Morgan Aviation, Transportation and Industrials Conference, slide 6
Delta is also implementing innovative new traveling solutions to produce incremental revenues from existing flights. Typically, this takes the form of a "branded fare initiative," which involves the consumer paying extra fees for additional amenities.
An example of this is Basic Economy, a service that is still below business class but offers certain amenities unavailable to the traditional flyer. On the company’s most recent quarterly conference call, it noted the substantial revenue impact Basic Economy and other branded fare initiatives are having on the business right now.
“We also completed the expansion of Basic Economy to 100% of the U.S. and Canada and have started rolling out the product in our international entities. Basic Economy is now available in more than 25,000 markets. Overall, our branded fare initiatives are on track to produce over $300 million of incremental revenue this year.”
As Delta continues to roll out new branded fare initiatives, the company’s revenues will increase, driving growth.
Competitive advantage and recession performance
As mentioned in the introduction, Buffett has noted the poor historical performance of airline companies in previous Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual reports.
“When Richard Branson, the wealthy owner of Virgin Atlantic Airways, was asked how to become a millionaire, he had a quick answer: “There’s really nothing to it. Start as a billionaire and then buy an airline.”Â
In the same report, Buffett described his initial disastrous investment into the airline industry.
Buffett ignored Branson’s advice and invested in U.S. Airways (a predecessor to the current American Airlines) preferred stock. The "Oracle of Omaha" deployed $358 million of Berkshire Hathaway’s capital into a U.S. Airways preferred security yielding 9.25%.
All was well for a few years, and Berkshire Hathaway collected healthy dividend payments – amounting to around $33 million per year – for the immediate years following.
But U.S. Airways suspended its dividend payments in 1994. The company eventually succumbed to the competitive nature of the airline industry. Buffett discussed this in the 1996 annual report:
“I overlooked the crucial point: USAir’s revenues would increasingly feel the effects of an unregulated, fiercely- competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline’s past record might be. (If history supplied all of the answers, the Forbes 400 would consist of librarians.)”Â
At the time that annual report was written, Buffett estimated the U.S. Airways preferred stock (still owned by Berkshire) was worth roughly its par value, and he was right not to sell when the dividend was suspended.
This experience, however, left Buffett with a bad taste in his mouth for the airline industry.
With this anecdote in mind, investors are right to worry about the performance of Delta during the next recession. After all, the airline declared bankruptcy in 2005 – what’s to stop it from doing so again?
The company currently has a stronger balance sheet that gives it slightly more flexibility during the next economic recession.
Delta is also committed to improving the quality of its balance sheet over time. The company currently has large unfunded pension liabilities that it is steadily reducing and aims to reduce its adjusted net debt to $4 billion by 2020.
Source: Delta Air Lines Presentation at the 2017 JP Morgan Aviation, Transportation and Industrials Conference, slide 11
Delta’s earnings per share performance during the last recession cannot be meaningfully measured since it was executing bankruptcy proceedings at the time. Qualitatively, though, Delta’s performace was very bad as it was in bankruptcy!
With that in mind, Delta should not be viewed as a very recession-resistant stock, and conservative investors are best off looking elsewhere (although today’s Delta is likely a much stronger enterprise than the 2005 equivalent).
Valuation and expected total returns
Delta’s expected total returns come from a combination of valuation changes, EPS growth and dividend payments.
One of the most attractive characteristics of Delta right now is the company’s very low valuation.
Delta reported adjusted EPS of $5.32 in fiscal 2016. The company’s current stock price of $50.40 is trading at a price-earnings ratio of just 9.5 times.
For context, the S&P 500’s average price-earnings ratio is currently 25.5 – more than twice the valuation of Delta.
This gives Delta’s shareholders the potential for serious upside if its valuation is revised upward, closer to market averages.
Source: Delta Air Lines Presentation at the 2017 JP Morgan Aviation, Transportation and Industrials Conference, slide 13
So why is Delta’s valuation so low?
It is certainly due to the company’s extremely poor performance during recessions. If Delta can prove itself to be more recession-resistant, then it will earn a higher valuation multiple from market participants.
The company's shareholders will also benefit from EPS growth.
Amazing, Delta has compounded its adjusted EPS at a rate of 30.6% per year over the past four years. This is due to the economy’s strong strength during that time – much of these gains will be taken away in the future because of Delta’s poor recession performance.
Over the full economic cycle, I believe Delta is capable of growing its adjusted EPS at a rate of 4% to 6% per year.
The company’s per-share earnings growth will be boosted by its generous share repurchases. Delta is on pace to complete its current $5 billion share repurchase authorization by mid-2017, and management will likely announce another upon completion.
Source: Delta Air Lines Presentation at the 2017 JP Morgan Aviation, Transportation and Industrials Conference, slide 12
The remainder of Delta’s future shareholder returns will be composed of its current dividend yield.
The airline currently pays a quarterly dividend of 20 cents, which yields 1.6% on the company’s current stock price of $50.40. While Delta is certainly a low-yield dividend stock, it has the highest dividend yield among Buffett’s airline holdings.
To sum up, Delta’s future shareholder returns will be composed of:
- 4% to 6% EPS growth, on average (more during a bull market, less during a bear market)
- 1.6% dividend yield
For long-term expected total returns of 5.6% to 6.6% before the effect of valuation changes.
Final thoughts
Delta has the highest dividend yield among Buffett's airline holdings, which makes it ideal for dividend investors looking to follow his airline play.
The recession vulnerability of this industry cannot be overstated, however. Delta (as well as American Airlines and United Airlines) has experienced bankruptcy in the past due to its poor recession performance.
Thus, before considering a stake in Delta Air Lines, please ensure it is an appropriate stock given your risk tolerance.
Disclosure: I am not long any of the stocks mentioned in this article.
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