Markets & Finance

Focus Stock: Should Delta Be on Your Radar?


S—P thinks the airline can leverage cost savings from its merger with Northwest and ranks the shares strong buy

From Standard & Poor's Equity ResearchWe view Delta Air Lines (DAL: recent price, 9) as the best positioned U.S. airline to take advantage of the industry environment entering 2009. Overall, we think the industry as a whole is likely to benefit from a sharp pullback in the price of oil and the resulting decline in jet fuel costs since late July 2008. We also believe the industry has already moved to pull down domestic seat capacity, which should allow supply and demand to remain in balance despite the expected decline in air travel demand that we see resulting from the global economic recession.

On top of the positive trends, we anticipate affecting the overall industry in 2009, we think Delta should be able to leverage its recently closed merger with Northwest Airlines to achieve cost and revenue synergies, allowing it to outperform U.S. industry peers financially over the next few years.

Investors clearly have been spooked by the overall stock market woes, worries about the economy, and concerns about the impact of both on the outlook for air travel demand. Year to date through Nov. 28, the S—P Airline subindustry index declined 29.1%, vs. a 39.0% decline in the S—P 500 over that same period. Year to date through Nov. 28, Delta shares were down about 41%.

In our view, investors initially pushed airline stocks down on worries related to oil prices, which closed at a high of $147.27 a barrel on July 11, 2008. Since then, oil has dropped about 64%, to $53, but airline stocks have not seen the benefit. Instead, we believe investors moved on to new worries about the U.S. and global economy, the housing, financial, and stock-market meltdown as well as the potential impact of those issues on air travel.

We think investors are discounting a worse impact on air travel demand than we expect and are not properly factoring in the lower-cost environment we see from the large and rapid drop in the price of oil. Specific to Delta, we believe investors are not properly appreciating the potential benefits of the Northwest merger. In our view, the shares, ranked 5 STARS (strong buy), provide a compelling opportunity for potential capital appreciation over the next 12 months.

COMPANY OVERVIEW

On Oct. 29, 2008, hours after receiving final approval from U.S. regulators, Delta Air Lines reshaped the U.S. airline industry by completing its merger with Northwest Airlines. This merger created the largest airline in the world, with an estimated $32 billion in annual revenues as a starting base. Internationally, the deal merges a carrier with a major presence in trans-Pacific flights (Northwest) with another that is strong on trans-Atlantic routes (Delta). The combined operation, operating from hubs in Atlanta, Cincinnati, Detroit, Memphis, Minneapolis, New York, Salt Lake City, and Tokyo, serves 375 destinations in 66 countries throughout the world and carries more than 170 million passengers annually. The combined operation will continue to operate under the Delta brand name.

We expect the combined entity to have strong liquidity and end 2008 with total cash of about $6 billion, which we see as more than adequate to fund operations and pay debt obligations and interest expense over the next two years.

We estimate that the new Delta will have an U.S. industry market share of about 23%, surpassing AMR's (AMR) American Airlines, which we estimate has 18% of the U.S. market. Stand-alone Delta had an estimated 13.5% share of the U.S. industry, while Northwest totaled nearly 9.5%. The company has noted that of more than 1,000 city-pairs operated by the two carriers prior to the merger, only 12 were served by both Delta and Northwest. Since there is so very little route overlap, the combined company is unlikely to cannibalize much, if any, of its own market share, and could actually expand share becaue of a better combined route network. This provides the opportunity to allow destinations for customers to markets they previously could not reach with either carrier.

We think the merger made sense given Delta's strong presence in the trans-Atlantic market and Northwest's strength in the Pacific. Also, as mentioned above, there is very little overlap among domestic routes, and the carriers have both already shed a great deal of debt and costs through the Chapter 11 bankruptcy process, although we still see the opportunity to cut underperforming routes and wring costs out of the system though consolidation. We think the combined entity will be able to increase its market share of business travelers and could have improved pricing power. Delta targets combined revenue and cost synergies of about $2 billion once the integration is compete, a goal we think is easily achievable.

There is little commonality among the Delta and Northwest fleet types, which should raise the complexity of the maintenance, spare parts, and training programs. In addition, Delta's decision not to eliminate hubs or routes ties its hands somewhat in its ability to cut costs, in our view. Also, we think both of these issues will be addressed over time, as Delta is likely to streamline the number of fleets it operates, and as ongoing capacity reductions should eventually drive the need for fewer domestic hubs, particularly in the Northwest U.S. Prior to the merger, Delta had already eliminated 4,400 positions and had trimmed domestic capacity about 12%-14%, and we expect more cuts to come over the next year.

EARNINGS OUTLOOK

For 2009, we forecast total revenues at the combined Delta will rise to about $36 billion. We see domestic capacity down about 13%, overall capacity down about 6%, and yields up about 8% with passenger load factor (the average percentage of seats filled) falling fractionally. We anticipate increases in revenues from cargo and ancillary revenues, due to increased cargo rates and the addition of fees for first and second checked bags as well as increased fees for reservations changes, phone reservations, and other services.

We see fuel costs falling to about 31% of total revenues, from an estimated 32% in 2008. Though we think the price of jet fuel is likely to drop some 50% if oil prices hold near current levels, and see fuel burn for the combined company dropping about 5%, part of this benefit is being offset by some out of the money fuel hedges that Delta entered into when oil was sharply higher. These will work off as 2009 progresses, but this offsets part of the gain from lower fuel costs.

We think opportunities exist for cost cuts in the areas of salaries, contract carrier arrangements (regional feed capacity, where Delta has been focused on getting improved contracts), and passenger service, as Delta works to combine operations. We see maintenance expenses rising as a percentage of revenues because of the increased complexity of operating a more diverse fleet.

Overall, we estimate earnings at the combined new Delta of $2.00 a share in 2009. We see a 49¢ loss for Delta as a stand-alone operating company for 2008 (excluding reorganization, asset impairment, and other one-time items). Delta recently came out with unaudited pro forma combined financials which show a year-to-date loss of $15.13 a share for the combined company for the first nine months of 2008, including $11.7 billion in reorganization and one-time restructuring and impairment charges.

VALUATION

Delta shares were recently trading at an Enterprise Value to-EBITDAR (that is, EBITDA plus aircraft rent) multiple of 3.2 times our 2009 EBITDAR estimate of about $3.4 billion. This is slightly below the average EV/EBITDAR multiple of the group of nine U.S. major airlines we cover, based on our 2009 EBITDAR estimates for these companies.

Our 12-month target price of $15 values the stock at an EV/EBITDAR multiple of about 4.5 times our 2009 EBITDAR estimate. This compares to an average EV/EBITDAR multiple of about 3.3 times our 2009 EBITDAR estimates for a peer group of nine major U.S. airlines we cover (including Delta). We think Delta deserves to trade at a premium to peers, reflecting Delta's position as the largest U.S. and largest global airline as well as the potential we see for revenue and cost synergies related to the merger.

We like to use EV/EBITDAR rather than EV/EBITDA since adding back aircraft rent makes for a more homogeneous comparison between those airlines that lease planes (aircraft rent) and those that mortgage them (depreciation and interest expense). Most airlines have a combination of the two in varying degrees.

We also think a potential expansion in the valuation for DAL and the airline group as a whole, as reflected by somewhat higher EV/EBITDAR multiples, is possible over the next year, as investors come to understand the positive factors impacting the industry, and look for companies likely to benefit from a lower oil cost environment. We believe that if Delta is able to execute its merger integration well, investors could reward the stock with an above-peers multiple, which we view as deserved.

CORPORATE GOVERNANCE

We view the company's overall corporate governance practices positively. Following the merger, the company has separate positions of chairman and CEO and the position of chairman of the board is a non-executive position. The board is also made up of a majority of independent directors. All members of the audit and compensation committees are independent directors. On the negative side, we think share ownership of Delta stock by executives and directors could be higher.

INVESTMENT RISKS

Airline stocks are generally much more volatile than the overall market, and for that reason, they are likely to carry a much higher risk profile than many stocks. Risks include the possibility that oil prices start to move back up toward record levels seen just a few months ago, that the downturn in the U.S. and global economy leads to a steeper drop in travel demand than we are expecting, and that price competition re-emerges in the industry which would lead to a decline in average airfares.

Delta also faces risks related to the integration of its merger with Northwest. The company could ultimately be unsuccessful in getting the cost and revenue synergies it predicts and the integration could move slower and be more costly than we thought. While we do not expect Delta will need to access capital markets due to what we see as a high cash level and only moderate cash usage expected for 2009, it may have difficulty tapping additional liquidity if needed due to the state of the financial markets.


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