There are a lot of risks in the airline industry, and high debt levels rank near the top, making things like cash flow and creditworthiness critical to airline success. Attaining an investment-grade credit rating in this industry is difficult, but Delta Air Lines (DAL +3.45%) has recently moved one step closer.
Rating agency opinions
Despite some extremely bad calls on mortgage-backed securities ratings, the top bond ratings agencies -- Standard & Poor's, Moody's, and Fitch -- are still key when it comes to determining how the market should perceive a company's debt.
To assign their ratings, these agencies look at all aspects of a company and rate company-issued securities based on their assessment. Most debts in the airline industry are rated non-investment-grade, or "junk," since they fall on the lower end of the creditworthiness scale.
However, there are notable exceptions in the airline industry. Right now, Southwest Airlines (LUV +3.55%) and WestJet Airlines (WJA +0.00%) currently hold coveted investment-grade ratings from S&P.
Delta Air Lines Boeing 757. Source: Wikimedia Commons.
Delta's upgrade
Although S&P still grades Delta's debt as non-investment-grade, the airline is now only one step away from joining Southwest Airlines and WestJet with investment-grade status.
Delta Air Lines' upgrade wasn't easy to get, but through significant debt reduction, growing profits, and an excellent cash-flow outlook, Delta has been able to pull ahead of its major legacy rivals.
Debt reduction
In 2009, Delta's adjusted net debt hovered around $17 billion, a massive number for almost any company. But the airline's management wasn't content to let the debt control the company, so they put the airline on a debt-reduction diet.
Since then, Delta has been consistently reducing its debt load, and it's down to $7.4 billion today. Not only has this approach put Delta in a better position should it need to borrow capital again, but management also estimates that adjusted net debt will fall to $5 billion by 2016, saving the airline $1 billion in annual interest expense compared with 2009.
Record profits
During the recession, airlines bled billions of dollars because of weak travel demand, but the industry as a whole has made a remarkably turnaround. Capacity discipline, consolidation, and improved travel demand have pushed airline profits to record levels at Delta Air Lines, United Continental Holdings (UAL +4.00%), American Airlines Group (AAL +4.83%), and Southwest Airlines.
Clearly, a turnaround in the bottom line is a positive for the ability to make whole on outstanding debt obligations.
Free cash flow king
Earnings are definitely something investors should watch, but free cash flow is particularly important in capital-intensive industries such as airlines. Thanks to many of the same tailwinds that have boosted profits, cash flows at major carriers have also moved higher in recent years.
However, Delta Air Lines is winning when it comes to the measure of free cash flow. While American Airlines Group is taking on large amount of capital expenditures over the next several years as it replaces much of its fleet, Delta has taken a more conservative approach to fleet modernization.
That's not to say Delta is brushing aside new aircraft purchases altogether, but by ordering comparatively fewer new planes, Delta has more free cash flow to use for things such as dividends, share buybacks, and debt reduction.
Credit-ratings agencies like this setup, since Delta can use this free cash flow to continue its debt-reduction plan, and it can provide a margin of safety if the airline industry were to slow.
One step away
Like airline stocks, airline debt is typically considered above average in risk, and ratings from credit rating agencies have reflected this assumption. But Delta is now only one step away from joining the small group of airlines with investment-grade credit ratings.
I see this as a bullish event for the company, as it should lead to lower future borrowing costs and could help the airline reduce its debt load even more quickly. Investors should keep an eye on whether Delta can secure an investment-grade credit rating in the future, as it could make the airline's debt even more attractive for bond market investors.
