After more than quadrupling in a two-year period, Delta Air Lines (NYSE:DAL) stock has given up some of its gains in the last few months. Delta shares have fallen more than 20% since mid-June because of a variety of worries, including the recent Ebola outbreak and uneven global economic growth.
For the most part, these worries are overblown. After its recent pullback, Delta stock looks quite cheap by most valuation metrics. That said, the airline business is full of risks, and Delta faces a few noteworthy threats that could impact its profitability a few years down the road.
The yen keeps falling
Delta has a large presence in Japan, which it inherited from Northwest Airlines. Delta flies to Japan from several of its hubs, and it also offers continuing service from Tokyo to several other destinations in Asia. Additionally, Delta flies from several cities in Japan to beach markets like Hawaii and Guam.
Delta's Japanese route network has been a liability recently. The dollar-yen exchange rate has risen from as low as 75 in late 2011 to approximately 110 today. As a result, Delta's Japanese revenues have fallen significantly in dollar terms. This is a particularly big problem in the beach markets, because most tickets for those flights are sold in Japan.
Delta has cut beach market capacity in order to mitigate this revenue pressure. However, its problems are likely to get much worse by 2016. For the past two years, the vast majority of the negative impact from the yen devaluation has been offset by gains on currency hedges.
Most of Delta's yen exposure is protected by hedges through 2015 at favorable exchange rates. After that, unless Delta can push through massive fare increases, its Japanese unit revenues will plummet. This will have a noticeable negative impact on Delta's earnings.
Lagging fuel economy could become a problem
Another potential risk for Delta is its reliance on older, less fuel-efficient jets. Most of Delta's major U.S. competitors have large orders for next-generation jets such as Boeing's 737 MAX and 787 Dreamliner or Airbus' A320neo and A350XWB. These jets will offer double-digit cost savings compared to the somewhat older jets typical of Delta's fleet.
Delta has stuck to its strategy of ordering current-technology jets that are nearing the end of their production runs, because it can get big discounts on these purchases. So far, this strategy has worked quite well. However, next-generation jets are just starting to make their way into U.S. airline fleets.
As Delta's competitors start to get their hands on more efficient planes toward the end of the decade, the Delta fleet may become a liability. Other airlines will be able to make a profit with lower fares because of their planes' superior fuel efficiency. This may encourage them to challenge Delta in key markets with lower prices, pressuring Delta's profit margin.
Delta gets more than half of its international revenue from the transatlantic market. In the past, it has benefited from multiple partnerships in the region -- a joint venture with Air France-KLM and Alitalia for travel to Europe, as well as a new joint venture with Virgin Atlantic for travel to the U.K. However, all of its partners in Europe are weak.
Virgin Atlantic has lost money in three of the last five years because of stiff competition from British Airways. Its current plan involves abandoning most markets other than the U.S. Instead, it is deploying more capacity to the U.S., with a particular focus on Delta hubs. However, these additional flights could over-saturate the market, which has been teetering on the verge of overcapacity.
The situation is even worse in continental Europe. Alitalia nearly went bankrupt this year before getting bailed out by growing Gulf airline Etihad Airways. Air France-KLM has also been losing money. These losses were exacerbated by a two-week pilot strike at Air France last month that may ultimately cost the company more than $600 million.
Delta's partnerships with all of these struggling carriers in Europe represents a significant risk. The steps these partners take to restructure may not be in Delta's best interests. For example, Alitalia is now tied much more closely to Etihad (a major Delta rival) than to Delta itself.
Still solid, but be careful!
Delta shares trade for about 9 times free cash flow, which is a bargain valuation. Furthermore, falling crude oil prices provide a nice earnings tailwind. All in all, Delta still seems to be in pretty good shape for long-term investors.
That said, shareholders should be aware of the three risks noted here: the falling yen, relatively poor fuel economy, and weak international partners. Delta may have to overcome significant headwinds from these elements in the next few years.
Adam Levine-Weinberg has no position in any stocks mentioned. 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.