Delta analysis

[Sniper@YourFeet]

This is mostly for the Delta guys, but . . .

Analyst Report | 12-30-2003
by Nicolas Owens

Thesis

Given the unsustainable nature of Delta's business model, we don't see any good reason to invest in the shares.

One of our concerns is that Delta's strategy is not viable over the long term. Generally speaking, a company can pursue one of two strategies. The first is to offer a differentiated product for which customers are willing to pay a premium. The other is to be the low-cost provider in a particular market. Delta seems somewhere in between, in a market that does not allow for much differentiation or tolerate a slack cost structure. Competition in the airline industry revolves largely around price, making air travel a commodity. The success of Southwest LUV over the years has been based on that carrier's low cost structure, which allows it to charge less than its competition, profitably. The fact that Delta's unit costs are 33% higher than Southwest's--and on par with the industry average--leaves Delta at a disadvantage in such a tight-margin business.

Another issue that we have with Delta is the volatility of its operating results. Because of the company's dependence on business travelers, earnings are very sensitive to the business cycle. In 1999, Delta made $1 billion in profit on almost $15 billion in sales. In 2000, it made $800 million on $17 billion in sales. In 2001, it lost $1.25 billion on $14 billion in sales, and last year it lost $1.3 billion on $13 billion in sales. This continues a pattern of large profits and losses in the industry that has persisted in every decade since the 1940s. Since deregulation in 1978, the airline industry as a whole has lost more than $11 billion. Given the current structure of the industry, we don't see this pattern ending anytime soon.

We think the most pressing reason to avoid investing in Delta--and most of its rivals--is the leverage. Delta has a lot of operating leverage, or high fixed costs. This is a very good thing when business is booming, but it has the opposite effect when business is in the dumps. More important, the firm has taken on loads of new debt to buy newer, more efficient aircraft. Recently, Delta has even used this debt to fund losses in its operations. This financial leverage exacerbates the poor operating performance of the airline, resulting in enormous net losses.

Most airline stocks--including Delta--are bad long-term investments. Wild swings in share price can make for tempting speculative trades, but over the long haul airlines have a terrible record for shareholders, and this isn't about to change.

Valuation
Because airlines are highly leveraged and extremely cyclical, it is difficult to estimate a meaningful fair value for their stocks. They tend to attract traders willing to take on extraordinary risk, instead of long-term investors seeking to minimize the risk of their investments. Because of Delta's unsustainable business model, volatile earnings, and extreme leverage, we have removed our star rating.

Risk
The primary risk facing the airline industry is the prolonged slump in demand for air travel, which tipped US Airways UAIR and United into bankruptcy and is forcing other airlines to tap all of their cash and financing reserves just to stay aloft. Meanwhile, the price of tickets and the value of airline assets remain under strong downward pressure.

Close Competitors
TTM Sales $Mil Market Cap $Mil
* Delta Air Lines 13,213 1,458
* AMR 17,153 2,064
* UAL 13,498 170
* Northwest Airlines 9,450 1,085
* Continental Airlines B 8,661 1,071
* Southwest Airlines 5,820 12,705
* JetBlue Airways 923 2,650
Data as of 01-01-04

Strategy
In the weak pricing environment, Delta is focusing on keeping costs as low as possible to stem the cash drain. The airline has cut staff and flights and launched Song, a point-to-point service meant to compete with low-cost carriers.

Management
Leo Mullin will step down as CEO in January 2004, paving the way for positive changes. Mullin has been Delta's chairman and CEO since 1997; he will retire as chairman when the board meets in April. We had some pretty serious beefs with the way Mullin ran the airline, particularly with his generous compensation relative to peers and the company's dismal financial performance. Gerald Grinstein, a board member and former CEO of Western Airlines (which Delta purchased in 1987) will take the CEO role, and Jack Smith, former CEO of General Motors GM, will become chairman. We believe a fresh start would help Delta weather tough competition from low-cost rivals. However, it's not clear to us how much fresh thinking an insider like Grinstein and the former head of a Big Three automaker can provide.

Profile
Delta Air Lines offers passenger and freight air-transportation services. The third-largest airline based in the United States, Delta operates hubs in its home city of Atlanta as well as Cincinnati, Dallas, and Salt Lake City. Delta's partners in the SkyTeam alliance include Aeromexico, Air France, Alitalia, Korean Air, and CSA Czech Airlines.

Growth
Delta is the third-largest airline in terms of revenue, yet it has managed to post decent growth compared with its biggest competitors. However, revenue performance will probably remain very weak over the next few quarters.

Profitability
In general, Delta is more profitable than its rivals, particularly American AMR and United UALAQ. However, we don't expect the airline to turn a yearly profit until 2004.

Financial Health
The company has taken on additional debt to keep the planes flying; 88% of its capital is now borrowed, counting operating leases as debt. It will be years before Delta can dig out of this financial hole.

 

[FDJ2]

In general, Delta is more profitable than its rivals, particularly American AMR and United UALAQ. However, we don't expect the airline to turn a yearly profit until 2004.


Good thing it's 2004.

 

[Joe Peeoznotz]

tough love

With $2.2B in cash and the assets all but mortgaged, it doesn't look good. I believe with the notes payable and the pension payment due in 04, DL will have to go 11 before the end of the year. The pilots want to grind this down to the last day before taking the concessions needed, and really I don't blame them.

 

[FDJ2]

"Predictions, Trends, Forecasts
2004 - Plan On A Great Year

Happy Holidays.

And plan on a Happy 2004, too. That’s because our analyses of airline trends, passenger growth, and other key indicators point to a very strong year ahead.

On January 5th, we’ll be looking at what we expect for 2004, and we’ll review how our 2003 predictions panned out, too. In the meantime, we thought we’d outline some of the key prediction areas we’ll be talking about in depth in two weeks.

Airline Industry: All signals – with the exception of fuel prices – are positive. The big news: mega-carrier systems are beginning to focus on their strengths. The "low fare carriers" are also re-assessing their operational models, too. We’ll be looking at the following trends:

Mega-Carriers: The circling of the wagons to defend against LCCs is drawing to a close. Operational and marketing counter-attacks are about to start. The oft-spouted mantra from some Wall Street types that airlines like AA, CO, and NW are static targets for LCCs is about to get shown for the myopic nonsense it is.
Low Cost Carriers: We’ll be looking at how this model is now under pressure, and some key players in this segment (which, again, is pretty small in terms of numbers) are now moving to fundamentally modify how they operate. A point to consider: Southwest will be under increasing pressure on the East Coast. Another point to consider: there could be consolidation in this industry segment.
Small Jet Providers: It's not a question anymore. There will be consolidation in this segment. These companies, which some rearview-mirror worshipers still call "regional airlines," are also facing fundamental shifts in their marketplace. These entities are in the business of providing lift (small jets and some turboprops - for the time being) under contract to major airlines, and they’ll be facing a situation where a glut of RJs and an excess SJPs will result in consolidation of this segment. Some big winners. Some big losers, too.
Capacity: Mega-carriers are adding capacity, which has resulted in cries of despair and disaster from some of the talking heads in the aviation media and in the financial world. Here’s a flash: much of these increases in capacity are risk-neutral, and/or cost-neutral. Add that to the fact that the economy is coming back, and the bottom line appears to be, well, a better bottom line.

Aircraft & Fleet Demand: As The Boyd Group’s fleet forecasts have predicted, the RJ demand curve is falling fast, and the demand for E-jets (new-technology 70-110 seaters) is now in its early stages. We’ll outline how the recent Air Canada order illuminates both trends.

Air Service Development: Economic realities will continue to manifest. The name of the airline game is survival, not expansion. Airlines will be looking for opportunities that represent big potential, but with zero risk.

Small & Rural Airports: The bar to gaining and recruiting air service continues to go up, potentially leaving smaller airports and entire rural areas high and dry.
Mid-Size Airports (Roughly 50,000 to 400,000 enplanements) – The tea leaves read well for most mid-size airports, but emerging trends in LCC costs and strategies are making entry into such markets a distant fantasy. All the civic hubris in the world, and regardless of how much money some airports might toss into the giant vapor hole of "traffic pattern studies" and the like, won't change airline economics. For airports anywhere south of 700,000 enplanements, Santa Claus is more likely to come to town than Southwest.
Hubsite Airports: Plan on STL continue to be pulled down as a connecting hub. Pittsburgh and US Airways are likely to come to a deal. Yield pressure – and traffic growth – at DFW, LAS & maybe one other hubsite due to major increases in LCC expansion. (Yes, LAS, too.)
What's out - "travel banks," "leakage studies," and travel-agency data. What's in - revenue guarantees, new economic pattern analyses, and Asian traffic generation. (Yup.) Just for starters."

Boyd

 

[AA717driver]

Year end. Time for the analysts to get out their Ouji boards... TC

 

[Ty Webb]

Here's my predictions:

1) T-Bags gets a shiny, new forklift in the Mulch Deprtment, but before he gets to use it even once, he gets canned for using the bosse's computer to pen nasty message board posts while "on the clock".

2) Joe Peenotz eats some bad birdseed and falls off of his perch.

3) FDJ2 decides that FDJ Sr was right, and leaves the Airlines altogether, opting instead to join the murky ranks of the Secret Order of Actuarials.

4) "FlyingBrian" regains his status as "Flying Brian" and escapes from the electronic plantation.

5) Enigma straps a JATO bottle on that tractor and takes farming into the 21st Century

6) FLB717 installs the new SpellChecker he finds in his Christmas stocking and becomes a Poet Laureate.

7) Ty Webb disappears from site (pun intended) for a few months in the Spring, in order to go through 737 upgrade, only to return in full force for the next year while sitting reserve.

 

[Joe Peeoznotz]

ty dye

My predictions for you:

AirTran spends millions stashed away from their "hold-up money," and modifies all their new 737's with expensive cabin hush kits to molify anyone sitting next to you.

Nepotism will continue at AirTran, as you get promoted to CA.

 

[Ty Webb]

Ahh, just waitin' for that birdseed to kick in.. . . . . . .


Squawk Squawk Thump.

 

[Redtails]

My prediction is that AA will return their Fokker 100s to service and modify them to 117 seat jets in two cabin classes; then fly them head-head on all AirTran flights out of DFW... a la Legend. They've certainly aligned themselves for a fight in either ORD or DFW with their reduction in service out of STL.

 

[Ty Webb]

Actually, that's pretty interesting, but we wouldn't be as easy as Legend:

1) New airplanes that are cheaper to operate than the Fokkers

2) $600 mil in the bank, and, while AMR's position has improved, they are still very weak for the time being.

3) A FF program

4) We have 45 cities to sell (don't know how many Legend had)

5) We have the ability to use 3 different sized aircraft on the routes

6) We have proven we can compete in a "fortress hub" environment

Still, though, I don't think our plans for DFW are as ambitious as the DFW Star was trumpeting.

 

[80drvr]

Re: tough love

With $2.2B in cash and the assets all but mortgaged, it doesn't look good. I believe with the notes payable and the pension payment due in 04, DL will have to go 11 before the end of the year. The pilots want to grind this down to the last day before taking the concessions needed, and really I don't blame them.

This analysis of Delta's situation is weak and certainly out of context for year end 2003. It is very subjective and might hold some water if it was done year end 2002. However, the so called analyst quanitifies absolutely nothing and fails to identify any trends in the market whether revenue or cost. The bottom line for Delta (and I don't have the answer) is this--are they producing positive operating cash flow or not.

 

[FLB717]

CMR, ASA = Making Cash 3rdQ (+50 Mil?)
DAL = Not making cash 3rdQ (-150 Mil?)

But I would NEVER at this point count DAL out, at all.

 

[Joe Peeoznotz]

Re: Re: tough love

This analysis of Delta's situation is weak and certainly out of context for year end 2003. It is very subjective and might hold some water if it was done year end 2002. However, the so called analyst quanitifies absolutely nothing and fails to identify any trends in the market whether revenue or cost. The bottom line for Delta (and I don't have the answer) is this--are they producing positive operating cash flow or not.

While I don't consider myself to be an anal list, it certainly doesn't take a genius to figure out a high percentage possibility of a problematic 2004. They will owe $400M to the pension, and have short term notes due of $1B. They have said they plan on increasing capacity 8-10%, and this with the hopes that demand must increase to prevent a catastrophic 2004. Add to that the new international route problems that can cut deeply into Delta's bottom line, and you have the ear-marking of a perspective difficult year. The dollar/euro deal will also add to their problems.

 

[T-Bags]

"1) T-Bags gets a shiny, new forklift in the Mulch Deprtment, but before he gets to use it even once, he gets canned for using the bosse's computer to pen nasty message board posts while "on the clock"."

IT HAS A SENSE OF HUMOR!!!

Actually, Ty, they don't let you drive the fork lift until you are a 3rd year associate.

"CMR, ASA = Making Cash 3rdQ (+50 Mil?)
DAL = Not making cash 3rdQ (-150 Mil?)"

It's all about the allocation of costs and revenue. If you fly from CAE-ATL then on to FRA on Mainline, what percentage of the revenue is allocated to CMR? Do you allocate the price of a FF CAE-ATL ticket? Or do you take the entre ticket price and allocate on a milage basis? It cuts both ways. If the added pax from an RJ increases the total pax to FRA, which allows for upguage in equipment from a 767-300 to a cheaper per seat mile 777, who gets credit for the cheaper costs at mainline? Case and point would be the fact that UAL show's it's RJ contracts to be big time money losers for the company. There is no doubt that RJ's have a very important role in the system (although I'd argue with the notion that RJ usage is the reason for DAL's relative success vs AMR, UAL). the only problem with the RJ's is the lack of a coherant and consistant philosophy WRT salaries. The various RJ pilot groups need to get together and set some mins. The constant whipsawing is out of control. Higher costs at the RJ operators will result in more rational usage (and food on the table for the pilots).

"Actually, that's pretty interesting, but we wouldn't be as easy as Legend:"

not as easy as legend, but I think the PHL-PIT route would serve as an example of what the fight will look like. FL will also be fighting SWA and it's operation at DAL.

"The dollar/euro deal will also add to their problems."

Please explain! During the heyday's of US dollar dominance vs european and pacific currencies the US carriers LOST market share. Seems that made the other operators CHEAPER. Currently the frenchies and germans are doing everything they can to encourage US tourism. Most "vacationers" will likely book a "package" deal that includes airfare from the cheapest operator (now us yanks) and severely discounted hotels. They won't feel the pinch of the exchange rate until it's too late (ie when they are already in Europe). business travelors will go with the best "value" from a "trusted" carrier. Due to lower costs and code share agreements, they may also find themselves increasingly on a "AF" coded flight. Add to this the US recovery (better than 8% 3rd Q growth) vs the stagnant Euro Zone (less than 1% 3rd Q growth), and I'd bet the international share for the majors will go up.

 

[Joe Peeoznotz]

Please explain! During the heyday's of US dollar dominance vs european and pacific currencies the US carriers LOST market share. Seems that made the other operators CHEAPER. Currently the frenchies and germans are doing everything they can to encourage US tourism. Most "vacationers" will likely book a "package" deal that includes airfare from the cheapest operator (now us yanks) and severely discounted hotels. They won't feel the pinch of the exchange rate until it's too late (ie when they are already in Europe). business travelors will go with the best "value" from a "trusted" carrier. Due to lower costs and code share agreements, they may also find themselves increasingly on a "AF" coded flight. Add to this the US recovery (better than 8% 3rd Q growth) vs the stagnant Euro Zone (less than 1% 3rd Q growth), and I'd bet the international share for the majors will go up.

MMMMMMMM.

Depends which side of the Atlantic you're traveling to. Europeans will find America a bargain, and of course they will buy r/t on American carriers. The French and Germans may subsidize the hotel rooms, but you still have to eat and site-see. This terror alert on some international flights needs to settle down. If it goes on for a few months, this could spook European travel for the remainder of the year. If the terrorist chatter is factual and they skyjack or blow-up a flight in the next few months, all bets are off. European Travel has been one of DL's saviors this past year.

 

[FDJ2]

CMR, ASA = Making Cash 3rdQ (+50 Mil?)
DAL = Not making cash 3rdQ (-150 Mil?)

But I would NEVER at this point count DAL out, at all.

FLB717 just a small point that is often overlooked. DAL had positive cash flow from operations of $201M in the third quarter. From the DAL filing:

"Delta had positive cash flow from operations for the September 2003 quarter of $201 million and generated an operating profit for two out of the three months."

DAL's annual EBITDA for September 2003 is + $877M.

I'm not wanting to paint too rosy of a picture, but the situation is not as dire as some believe. With over $2.7B in cash, over $800M in annual positive cash flow for 2003, an improving revenue picture, an expected increase in capacity of 8-10% in 2004 and an improving business climate, there's still quite a bit of fight left in DAL.

 

[T-Bags]

"The French and Germans may subsidize the hotel rooms, but you still have to eat and site-see."

Like I say, by the time you figure out that it costs $50 US to see the eiffel tower, it's too late, you are already in Europe. But again, the rapid expansion in the economy and potential arbitrage opportunities due to the very weak dollar (wonder how the old "big mac" index looks now), and I think that international travel will be on the up swing. FWIW, many europeans chose the higher priced Euro carriers over the last two years because they were worried about terrorism on US jets. The recent alerts, and the hesitance on the French, Germans and brits to implement real security measures, may result in the US Flags being considered the "safer" route.