Among major carriers, Delta Air Lines (NYSE:DAL) has proved to be a standout over the past few years. Not only is the Atlanta-based carrier producing record profits but it's also become the only one of the big three legacy carriers to pay a dividend or join the S&P 500 Index.
Perhaps this is why Delta Air Lines shares are up over 110% since this time last year. But to continue those gains, Delta has some pretty bullish five-year targets in mind as noted in its presentation at a recent transportation conference.
Margin and earnings growth
Some investors may wonder what drove Delta shares to more than double over the past year and much of that can be explained with increasing profitability at the airline. Net income for 2013 totaled $2.5 billion excluding a one-time tax related gain compared to 2012's net income of $1.6 billion.
In its five-year targets, Delta is looking to increase it operating margin to 11% to 14% compared to just under 10% now. Increasing operating margins not only provides stability in a traditionally thin margin industry, but increasing airline operating margins by even just a few percent can mean big gains for high-revenue companies like Delta.
This increase in operating margins feeds into another Delta goal: increase earnings per share 10% to 15% annually after 2014. It's a tall order, but if the airline can keep costs under control while continuing to generate greater revenue, it looks within reach.
Cash flow, dividends, and share buybacks
In its five-year targets, Delta is looking for $6 billion in annual operating cash flow and $3 billion of free cash flow. Having this much free cash flow on hand would give the airline a lot of flexibility in terms of reinvestment, debt reduction, and capital returns.
I'll get into debt reduction later, but I will first focus on reinvestment opportunities. To win over the highest-paying passengers, Delta needs to provide them with the product they want and the airline has realized this well. To take a greater part of the New York market, especially popular among high-revenue business travelers, Delta invested $1.4 billion in renovating Terminal 4 at JFK International as well as Terminal 2 at the same airport.
Delta is even investing $770 million to make economy seats nicer for ordinary travelers. Through 2016, 225 domestic narrowbody aircraft will get upgraded entertainment, lavatories, and galleys. Although Delta has not joined its rivals in placing large numbers of new aircraft orders, the airline is expected to order new aircraft to replace certain parts of its fleet. But with a larger amount of free cash flow and more limited new aircraft purchases, Delta may be able to pay cash for some of its new aircraft and avoid increasing its debt levels.
Having such a large amount of free cash flow available also gives Delta the opportunity to pursue dividends and share buybacks. Delta made headlines earlier this week by raising its dividend 50% and increasing its share buyback to $2 billion.
The connection between having low debts, strong profits, and capital returns at airlines is pretty clear. Southwest Airlines (NYSE:LUV) and Alaska Air Group (NYSE:ALK) are the other two largest dividend and buyback participating airlines and both of them carry low debt loads while reporting strong profits.
On top of controlling costs, growing profits, and returning capital to shareholders, Delta has also taken an aggressive approach toward debt reduction. Net debt peaked at around $17 billion in 2009 but the airline has been on a steady debt reduction plan since then that saw adjusted net debt trimmed to $9.4 billion by the end of 2013.
The debt reduction plan is continuing at Delta with a goal of $7 billion of adjusted net debt by 2015 and $5 billion of adjusted net debt by 2016. Not only does this debt reduction lower interest expense and boost Delta's credit rating, but it also positions the airline better for tough economic times, when high levels of debt can become a burden on any company.
A long-term investment
With major progress over the past few years, Delta is laying out aggressive targets for the next five years in the areas of operating margins, EPS growth, cash flow, and debt reduction. If Delta can continue to execute, these targets look within reach and stand to improve many aspects of airlines that investors follow closest.
With this in mind, Delta Air Lines remains one of my favorites among airlines and is worth a further look for any airline investor.
Alexander MacLennan owns shares of Delta Air Lines and has the following options: long January 2015 $22 calls on Delta Air Lines, long January 2015 $25 calls on Delta Air Lines, and long January 2015 $30 calls on Delta Air Lines. This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.