Airline stocks rallied through 2013 and 2014, with Delta Air Lines (NYSE:DAL) being a major contributor to the gains. With its shares up over 40% in 2014, Delta is showing investors that airline stocks can outperform the market.
Shareholder capital returns
Airlines have rarely been considered dividend stocks, and much of the industry's existence has depended on retaining enough capital to manage debt and capital expenditures while fighting rivals in cutthroat competition.
But with Delta's reduced debt and less spending on new aircraft, the airline has been redirecting cash flows to its shareholders through dividends and stock buybacks. In 2013, Delta kicked off its plan by launching a $500 million share buyback program and a $0.06 per quarter dividend. For this year, the airline is boosting capital returns even further with a $2 billion buyback while increasing its quarterly dividend to $0.09 per share.
In 2009, Delta Air Lines had a whopping $17 billion in adjusted net debt but the airline's management has made debt reduction a top priority. That move has led to a massive reduction in adjusted net debt, down to $9.4 billion at the end of 2013.
But Delta isn't stopping here. In a June presentation, Delta officials noted the airline's target of reducing adjusted net debt to $5 billion by 2016. The airline says this goal will have a positive effect on earnings, as it will reduce interest expense to $350 million, which would be $400 million lower than 2014 and nearly $1 billion lower than 2009.
Freeing up cash flow
In the same June presentation, Delta said it's targeting $3 billion in annual free cash flow in its five-year plan and that the airline is already finding ways to achieve this target. As I previously mentioned, debt reduction is helping to reduce interest expense, thereby freeing up cash to use for other purposes.
Delta has also avoided going on an aircraft buying spree like some of its rivals, opting instead for lower capital expenditures by refurbishing older aircraft and being more selective in new aircraft purchases. This approach means fewer cash-consuming aircraft lease payments, allowing the savings to be used in other ways.
By not having this cash already committed to existing expenses, Delta has more room to raise dividends or increase share buybacks, things investors don't often find in airlines.
Higher profits have been a big story for the airline industry for the past few years. Since the recession, airline profits have bounced back remarkably well thanks to industry consolidation, new fees and services, and higher travel demand.
For 2013, Delta reported net income, excluding special items, of $2.7 billion -- well above the $1.6 billion profit for 2012. For this year, Delta is forecast to post $2.5 billion in earnings; however, this is the first year Delta will factor in a 39% tax rate.
Even though Delta will still be able to make use of its deferred tax asset, obtained from previous losses carried forward, to not actually pay taxes this year, the airline recognized the value of the deferred tax asset last year and has to apply this tax rate to the earnings it reports. If it were not for this tax effect, Delta would be on track to earn around $4 billion this year, comparing favorably with 2013 earnings.
Delta Air Lines shares have vastly outperformed the market through both 2013 and 2014, thanks to higher profits and smart capital allocation. With more free cash flow available, Delta has boosted both its dividend and share buyback while continuing to reduce its debt levels.
This airline is flying high right now, and if management continues to meet expectations, Delta's move higher stands a good chance of continuing.