(By Kevin Donovan) To buy airline equities recalls poet Emily Dickinson's observation: "Hope is the thing with feathers." Investors with a weakness for gambling have been known to pile in and out of the flighty sector with every wiggle in fuel cost and air fares.
But that kind of share price volatility seen in the past could be on the wane. The biggest reason: consolidation and the resulting reduction in capacity. Trade group Airlines for America says members plan to chop off 12% this year in available seat miles (ASM), a key measure of industry capacity.
Also recommending the sector is the recent decline in fuel prices, the biggest input cost for airlines.
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Given these two trends, we like Delta Airlines (DAL). Though its momentum has stalled in the last month with the share price down 3.2%, it outperformed peers' 6.2% decline. Delta shares are down 4.8% in the last 12 months, vs. peer's 15.2% decline, but are up 41.4% in the last six months, vs. a 6.8% decline for the industry.
At $10.14, Delta trades at an enterprise value to EBITDA multiple of 4.34, in line with the industry average of 4.4. But given its strategic moves to right-size capacity, control fuels costs and reduce debt, we believe it deserves a premium.
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Delta said last week it plans to cut capacity 3-4 percent this year, with the biggest route reductions coming in trans-Atlantic flights. This news hit the stock hard, but the airline's president, Ed Bastian, called it a "proactive" measure. We agree and view the cutbacks as a positive.
Jet fuel costs have declined 4.3% in the last week, 5.49% in the last month and 0.79% in the last year, according to IATA, a trade association.
Delta has taken a unique step in meeting its fuel demand, becoming the first airline to own an oil refinery. It purchased a Pennsylvania facility from Phillips 66 for $150 million and believes the refinery will save $300 million in fuel costs annually. Delta intends to spend $100 million to upgrade the refinery and expects it to provide about 80% of the company s domestic jet fuel needs.
Adjusted net debt stands at about $12.2 billion, down from $12.9 billion at the end of 2011. It has shed $5 billion in debt the past two years through cost cuts that have increased cash flow for de-levering. Management is aiming to cut total debt to $10 billion by next year.
The story is not without risks. Obviously, the shaky outlook for world economic growth is the biggest one. And Delta's industry high debt to total capital level is noteworthy.
Nevertheless, we see hope as more than feathers. Delta is nicely positioned to outperform and we recommend purchase.