One of These Airlines Is Not Like the Others

In the last few weeks, several Foolish readers have asked why I think Delta Air Lines (NYSE: DAL  ) is a better investment than either of the other legacy carriers, United Continental (NYSE: UAL  ) and American Airlines (NASDAQ: AAL  ) . After all, all three airlines are similar in size, but Delta has the highest market cap at $29 billion.

Delta Air Lines has the highest market cap in the airline sector.

Value investors instead might be tempted to go with American or United, which are worth approximately $27 billion and $17 billion, respectively. But both competitors are "cheap" compared to Delta for a very good reason. Delta is becoming a reliable cash cow, generating billions of dollars in free cash flow annually. By contrast, American and United have heavy capital commitments that will soak up most of their cash flow for the next five years or more.

The importance of cash flow
Investors look for a lot of different things in potential investments. Some investors are looking for stocks with low P/E ratios, others want high dividends, and others want big earnings growth. But ultimately all investors are after one thing: free cash flow.

High reported earnings growth and low earnings multiples are great things to look for, all else being equal. Yet at some point, a business needs to generate cash to be worth something. Free cash flow provides money that can be used for acquisitions, dividends, share repurchases, or even future investments. Big dividends are great, too -- but a company with no free cash flow won't be able to sustain its dividend.

From a high-level perspective, there are two main inputs that influence free cash flow. First, higher earnings will improve free cash flow, all else equal. Second, higher capital expenditures will reduce free cash flow.

Delta is a cash cow
Delta's success stems from a strategy that has allowed it to deliver impressive earnings growth without heavy capital expenditures. At the company's investor day a few months ago, Delta laid out a target of generating at least $5 billion in annual operating cash flow and investing about half of that back in the business. That would leave at least $2.5 billion in free cash flow.

By keeping older planes like this 757 flying, Delta has held down capital expenditures.

Delta is already well on the way to meeting this ambitious target. In 2013, the company generated nearly $2 billion in free cash flow. This allowed it to continue reducing its debt load and pension burden, while also beginning a regular dividend and a share repurchase program.

Delta's free cash flow ambitions are further supported by its rising earnings power -- it reported a $2.7 billion pre-tax profit last year -- and low capital commitments. Delta has just $9.1 billion in aircraft purchase commitments on its books, of which $6.4 billion comes in the next five years.

Based on Delta's plan to produce at least $5 billion in annual cash flow and reinvest half of that, the company could add another $6 billion of capital expenditures over the next five years while staying within its budget. That leaves plenty of room for additional aircraft orders, as well as other capital expenditures, such as aircraft retrofits, maintenance facility upgrades, and software.

A different story at American and United
Whereas Delta has recently become a big cash cow, American and United are not at that point yet -- and they probably won't be for many years to come. First, neither American nor United has been as profitable as Delta recently.

American may soon catch Delta in terms of profit, but free cash flow still lags. Photo: American Airlines

As noted above, Delta earned a pretax profit of $2.7 billion last year. By contrast, American's pretax earnings totaled just under $2 billion, and United's pretax earnings lagged far behind at $1.1 billion. American Airlines is likely to close some -- but not all -- of the gap with Delta this year. Meanwhile, United's weak Q1 performance will make it hard for the company to do better than keep pace with Delta's profit growth in 2014.

Over time, American and United may be able to close the earnings gap with Delta (although I am skeptical in United's case). But the second driver of free cash flow is what really sets Delta apart: capital expenditures.

Whereas Delta has found a formula that allows it to deliver top-tier earnings power without relying on heavy capital expenditures, American and United are trying to catch up through fleet renewal. Both companies have comparatively heavy capital spending plans, particularly American Airlines.

Recall that Delta has $9.1 billion of spending commitments related to new aircraft, of which $6.4 billion is planned for the next five years. By contrast, United's capital commitments total $23.9 billion (which does include some nonfleet costs). United projects that capital spending will average just under $3 billion for the next few years. In fact, capital expenditures will likely stay around this level or higher for the next 10-15 years due to the age profile of United's fleet.

Unlike Delta, United is already replacing most of its 757s.

American's capital commitments are even higher. The company's aircraft commitments total a staggering $35.9 billion, of which $19.6 billion is scheduled for the next five years. As a result, even if American can eventually match Delta dollar for dollar in terms of earnings, the vast majority of its operating cash flow for the next decade will be spent on new aircraft.

Delta is the cash king of these three airlines
In short, Delta has a higher market cap than the other two legacy carriers because it deserves to be more highly valued. American Airlines may catch Delta in terms of profitability in the next few years, but it needs to spend tens of billions of dollars on new planes in order to do so. On the flip side, United's profitability has lagged the rest of the industry by a wide margin, and it also has higher than normal capital needs for the foreseeable future.

Among these three airlines, only Delta provides the ideal combination of high earnings power and relatively modest capital spending. This will allow it to throw off billions of dollars in free cash flow each year, which it can use to reward shareholders through bigger dividends and share repurchases.

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