Does Delta Airlines, Inc. Deserve an Investment Grade Credit Rating?

Nearly 10 years removed from bankruptcy, management at Delta Airlines, Inc. (DAL 0.43%) has increasingly made the case that the company deserves an investment grade credit rating, the highest credit rating awarded to debt issuers. Near the beginning of the company's most recent investor presentation, which you can peruse in its entirety here, the carrier puts forward this impressive slide:

Source: Delta Airlines.

Under the blue header, Delta lists an "investment grade balance sheet" as one of its long-term goals. What exactly does this phrase mean? The term speaks to the creditworthiness of a bond investment from the lender's perspective. If you were to lend money to an industrial concern like Delta, you'd want to know that the company exhibits a high degree of liquidity and solvency. Liquidity refers to the amount of resources on hand that can be used to meet current obligations like bond interest payments. Solvency concerns a company's ability to meet long-term obligations. 

Delta is improving on both fronts, having been recently upgraded to "BB" by Standard & Poor's Rating Services. S&P describes any company holding this rating as "Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions." The status is two upgrades away from an investment grade rating.

While S&P has indicated that Delta's creditworthiness is rising, investors should consider the following. The next step up for Delta is BB+, "considered highest speculative grade by market participants." The notch above BB+, coveted "BBB-" status, is "considered lowest investment grade by market participants." There is much subjectivity and a lot of gray area between the "highest speculative grade" and the "lowest investment grade."

Yet this thin line between the next two ratings makes all the difference. At the moment, lenders charge a premium to buy Delta's debt, and if the airline reaches investment grade status, its borrowing costs will be lowered. Only a handful of airlines worldwide currently hold an investment grade rating from any of the three major ratings agencies, and only two are U.S.-based carriers: Alaska Air Group (ALK -0.99%) and Southwest Airlines (LUV -0.91%). Let's take a look at how Delta stacks up against Alaska and Southwest on three important metrics a lender might consider before purchasing Delta's bonds.

Debt to capital: A look at leverage
The debt-to-capital ratio is one way to evaluate how much a company is leveraged. The basic equation is: Debt / Shareholders Equity + Debt. This ratio is a measure of solvency.

As opposed to the more commonly used "debt-to-equity" ratio, debt-to-capital factors in a company's total capital base -- that is, both the equity the company has plus its outstanding debt. In industries with high fixed assets like the aviation industry, it's often more instructive to understand a company's obligations in context of its capital. Delta has made tremendous progress in lowering this particular ratio. As you can see below, the steep reduction that occurred in 2013, in which Delta more than halved this ratio, speaks volumes to investors about the company's determination to leave its legacy of overleveraging behind. Yet it still has much progress to make to exhibit the metrics of its investment grade peers:

ALK Debt To Capital (Quarterly) data by YCharts.

Both Alaska and Southwest carry a debt-to-capital ratio of around 27%, thus Delta's ratio is two-thirds higher by comparison.

There's a bit of subtlety investors should take note of when understanding Delta's creditworthiness vis-a-vis the clean balance sheets of Alaska Airlines and Southwest Airlines. In addition to its long-term debt load of $10.1 billion, the company carries another $11.5 billion of long-term pension and post-retirement liabilities. So its total long-term liabilities are disproportionately large relative to its capital.

Source: SEC filings. All dollar figures in billions.

While Alaska and Southwest maintain total long-term liabilities of less than 75% of total capital, Delta's long-term liabilities actually exceed its total capital base. 

Times interest earned
Times interest earned is another useful ratio that addresses the number of times a company can cover the interest payments on its debt. Like the debt-to-capital ratio, this metric probes a company's solvency. It's a measure of balance sheet strength, and is one of the ratios a shareholder should apply to test the proposition that a corporation holds "an investment grade balance sheet." The primary formula is earnings before interest and taxes, or EBIT, divided by interest payable on debt. Delta sports a positive "TIE" ratio, and shows the ability to meet interest payments six times over from earnings:

ALK Times Interest Earned (TTM) data by YCharts.

Again, compared to its investment grade competitors, Delta needs to show a bit more improvement. Southwest can meet its interest obligations 20 times over, and Alaska has an EBIT equal to 81 times interest payments. Alaska's extremely high ratio can be taken as both a marker of its success in debt reduction over the last five years as well as an indication that its balance sheet has capacity for additional leverage at present.

Efficiency: Operating cash to assets
Finally, we may want to review a business performance measure, operating cash to assets. This metric is simply operating cash flow divided by total net assets, and measures operational efficiency. Relating the balance sheet to the statement of cash flows, the equation gives investors a thumbnail gauge of how proficiently a corporation generates cash flow from its assets.

Operating cash to assets is effective when you're comfortable with a company's potential to meet debt obligations but want further comfort regarding its ability to produce cash flows into the future. As has been the pattern with the other metrics we've reviewed, all three airlines show admirable performance on this count, but Delta needs to gain on its rivals in the coming years. Note: The "CFO" in the chart legend refers to "cash from operations" -- it's the same as operating cash flow:

ALK CFO to Assets (TTM) data by YCharts.

First deserve, then desire
Delta Airlines is a mature business with solid profitability and enticing growth prospects. It has a relatively young fleet, and shows increasing ancillary revenue -- the non-ticketing revenue that often brings the highest margin to an airline's bottom line. From the slide shown at the outset of this article it's clear that Delta has restructured its business quite efficiently post-bankruptcy, setting immediate goals to outpace S&P industrial companies in earnings per share, or EPS, and return on invested capital, or ROIC.

However, from a review of just a few important metrics, it's also apparent that Delta doesn't deserve an investment grade credit rating -- yet. If the company continues to pay down its debt and control its post-retirement benefits, it will reach investment grade status soon, perhaps in late 2015 or early 2016. At the moment, however, bondholders are correct to charge a bit of a premium when lending to the carrier.