I won't sugarcoat this: Traditionally, airlines have not been great investments, at least not for those interested in equities. Still, there's strong reason to believe that won't always be so.
Delta Air Lines(NYSE: DAL) is an excellent example of a stock that can buck the trend and remain the pick of the transportation sector. Here's why the stock is a great value.
Equity investors and bond investors view airline stocks differently
With even Warren Buffett having lost money on airline stocks in the past, it makes sense that ordinary investors approach the matter with circumspection. The industry's long-term issue comes down to its inability to generate a return on capital necessary to cover its cost of capital.
As the International Air Transport Association argues, "Even prior to the COVID-19 crisis, equity owners had not been rewarded adequately for risking their capital," because "average airline returns have rarely been as high as the industry's cost of capital."
That's bad news for equity investors, since the average airline isn't generating any economic value. But it's not bad news for debt providers because they have been rewarded for putting up capital, with their investment backed up by a relatively liquid asset, the airplanes themselves. It's also good news for airplane suppliers, whose profits, you could argue, are supported by equity investors' losses.
Why Delta is different
At this point, I would understand why investors might want to run away and start looking at aerospace suppliers, but bear with me a second because I think Delta Air Lines is an option worth looking at very closely.
Digging into the recent presentation at the J.P. Morgan Industrials Conference, Delta's management noted that the recovery in air travel means it's already significantly covering its cost of capital and is set to improve its cover in the coming years.
Delta Air Lines
2022
2023
Long-Term Target
Return on invested capital
8.40%
13.40%
Mid-teens
Weighted average cost of capital
8%
8%
8%
Data source: Delta Air Lines.
In other words, Delta is now generating value for equity investors. It's doing so because of a significant increase in earnings and cash flow as the commercial aerospace industry recovers from the travel restrictions imposed during the worst of the pandemic.
The table below shows the company's improvements in earnings and cash flow. I've also included its adjusted debt to earnings before interest, taxation, depreciation, amortization, and rent (EBITDAR) multiple. This is a typical leverage ratio that debt investors use for gauging credit quality, demonstrating Delta's creditworthiness improvement.
Delta Air Lines
2022
2023
2024 Estimate
Earnings per share
$3
$6.25
$6 to $7
Free cash flow
$200 million
$2 billion
$3 billion to $4 billion
Adjusted debt to EBITDAR
5X
3X
2X to 3X
Data source: Delta Air Lines.
Indeed, CEO Ed Bastian called out the issue during the J.P. Morgan presentation when he said, "We maintained with Moody's throughout our investment-grade status, and we're just one notch below with Fitch and S&P, and we certainly expect at least our metrics will be there by the end of this year in terms of our leverage ratios."
Using cash flow to pay down debt (adjusted debt fell from $32.9 billion at the end of 2022 to $29.2 billion at the end of 2023) is crucial to improving Delta's balance sheet. That's good news for debt holders and equity holders alike.
Delta's valuation remains highly attractive
Trading on a forward price-to-earnings ratio of just 6.8 times Wall Street earnings estimates and 8.1 times the midpoint of management's free-cash-flow guidance, it's clear that the market is expressing some skepticism over Delta's prospects.
Image source: Getty Images.
Indeed, the stock sold off after its latest earnings report revealed growing cost pressures and slowing revenue growth.
But the company's focus on the premium market (the average Delta customer has a household income of over $100,000 a year, according to Bastian) while being conservative over increasing capacity continues to ensure ongoing margin expansion.
Meanwhile, the premium market continues to grow strongly, international travel is coming back, and Delta also has lucrative loyalty-program revenue driven by its relationship with American Express.
It all adds up to make Delta the pick of the transportation industry and a rare stock to invest in confidently in the airline sector.
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American Express is an advertising partner of The Ascent, a Motley Fool company. JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends JPMorgan Chase. The Motley Fool recommends Delta Air Lines. The Motley Fool has a disclosure policy.
