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Delta Air Lines Stock Remains Undervalued

By Adam Levine-Weinberg - May 25, 2019 at 10:09AM

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Investors and analysts are underestimating Delta's long-term profit growth potential -- and valuing the stock at a steep discount to the market.

Shares of Delta Air Lines ( DAL -1.80% ) have been trending downward for the past few weeks, as investors weighed the risks from growing trade tensions with China. An analyst report added to the selling pressure early last week, as Morgan Stanley downgraded the stock to neutral, warning of falling free cash flow and risks to earnings growth.

However, Delta's lower free cash flow is the result of its heavy investments in upgrading its fleet. Those investments are starting to pay off -- and fleet renewal is just one of several initiatives to boost unit revenue or reduce unit costs. Together, they position Delta to achieve meaningful earnings growth over the next few years. With Delta Air Lines stock trading for just eight times forward earnings, investors appear to be underestimating the airline giant's future prospects.

Unit cost trends have improved dramatically

As recently as 2017, Delta's adjusted nonfuel unit costs rose 4.3% year over year. By contrast, adjusted nonfuel unit costs inched up just 1.4% last year. Management expects cost trends to improve further in 2019, with adjusted nonfuel unit costs rising about 1%. Delta got off to a good start, posting a 0.2% decrease in adjusted nonfuel unit costs last quarter.

It's true that Delta may face some cost pressure from higher pilot pay next year, as the current pilot contract becomes amendable at the end of 2019. However, savings from the company's "One Delta" cost-cutting initiative should double to at least $1 billion next year, mitigating that headwind.

Delta's aggressive fleet investments will add to the company's cost momentum. The carrier is set to add 207 new mainline aircraft to its fleet between 2019 and 2021, enough to replace nearly a quarter of its mainline fleet. More than 70% of those planes will arrive in the next two years.

A Delta Air Lines Airbus A321 jet parked on the tarmac

Delta will replace nearly a quarter of its mainline fleet between 2019 and 2021. Image source: Delta Air Lines.

For the most part, Delta will be replacing aging MD-88s and MD-90s with new Airbus A321s and A321neos. As of the end of March, it had 116 remaining MD-88s and MD-90s set to retire in the next two to three years and 105 A321s and A321neos scheduled for delivery between now and the end of 2021. The Airbus jets will be much cheaper to maintain. They are also larger, so pilot pay is quite a bit lower on a per-seat basis.

These fleet upgrades are also boosting Delta's fuel efficiency, offsetting the impact of high fuel prices. Last quarter, fuel efficiency improved 2.1% year over year. The rate of fuel-efficiency gains could accelerate as Delta starts to add more next-generation aircraft to its fleet.

The AmEx tailwind will keep growing

Cost control is just one side of Delta's margin expansion plan. The company also has several big revenue growth drivers in place, the most important being the carrier's lucrative credit card partnership with American Express ( AXP -0.53% ).

Delta is a valuable partner for American Express, due to its huge base of wealthy frequent flyers. Annual spending on Delta-AmEx co-branded credit cards is rapidly approaching $100 billion.

As a result, American Express recently locked up a long-term renewal with Delta that runs until 2029. Delta expects this relationship to drive $7 billion of high-margin revenue annually by 2023, up from $3.4 billion last year. Growth of the Delta-AmEx co-branded cardholder base, higher spending by existing cardholders, and a better revenue split for Delta will all contribute to this growth.

Premium seat inventory will keep rising rapidly

The expansion of Delta's premium seat inventory represents another key revenue growth driver for the company. In the domestic market, fleet upgrades are increasing the number of available first class and extra-legroom seats. Delta is getting very good at selling those seats for a premium rather than just giving them away as free upgrades.

Premium economy seats on a Delta Air Lines plane

Delta will offer premium economy on all of its international widebodies by late 2021. Image source: Delta Air Lines.

Delta Air Lines is taking even more dramatic action on international routes. In addition to replacing some of its aging Boeing 767s with state-of-the-art A330-900neos, it plans to retrofit its full international widebody fleet with premium economy sections by 2021.

As a result, the number of premium seats per widebody aircraft will increase by 40% between 2018 and 2023. Management expects a big revenue benefit from offering customers more premium seating options on long-haul routes.

A deeply undervalued company

In any given quarter or year, a spike in fuel prices, economic weakness, or overcapacity could prevent Delta Air Lines from growing its earnings. But looking out over the next three to five years, the carrier has substantial earnings growth drivers that should more than offset any headwinds it may face over that period.

Fleet renewal and other cost-cutting initiatives will offset Delta's typical cost inflation and reduce its fuel consumption. The American Express revenue stream will continue to grow. And greater premium seat inventory will help Delta capture higher fares.

With earnings likely to rise significantly in the coming years, Delta Air Lines stock is set to fly higher as well -- sooner or later.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Delta Air Lines, Inc. Stock Quote
Delta Air Lines, Inc.
DAL
$35.98 (-1.80%) $0.66
American Express Company Stock Quote
American Express Company
AXP
$155.94 (-0.53%) $0.83

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