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Delta Air Lines, Inc. Looks Like a Great Buy Before Earnings

By Adam Levine-Weinberg - Oct 5, 2015 at 9:25AM

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Delta expects to reach the upper end of its margin guidance for Q3, but investors still aren't satisfied.

Delta Air Lines ( DAL 1.10% ) stock fell 1% on Friday even as the market made solid gains. Apparently, investors weren't pleased by Delta's September unit revenue and its updated third quarter guidance.

It's hard to comprehend investors' pessimism, though. Delta just wrapped up the best quarter in its history. Furthermore, the company is almost certainly past the worst of its unit revenue declines. With the stock trading at a bargain valuation, this could be a great time to scoop up some shares of Delta.

A solid update
Back in July, Delta had projected that its Q2 unit revenue would decline 4.5%-6.5% year over year. However, it expected its operating margin to reach 19%-21%, up from 15.8% a year earlier. This margin expansion was to be driven by fuel savings, with Delta expecting to pay $1.90-$1.95 for jet fuel in Q3, compared to $2.90 in Q3 2014.

Delta's investor update last week improved on all three of these metrics. The company now expects its unit revenue to decline 4.5%-5.5% for the quarter -- thus cutting out the lower end of the original guidance range -- while its average fuel price is projected to be $1.80-$1.85. As a result, Delta now expects to report an operating margin of 20%-21%.

Delta expects to post a record profit for the third quarter. Photo: The Motley Fool

This level of profitability was virtually unheard of in the airline industry just a couple of years ago, even in the seasonally strong third quarter. Even this year, when airlines are benefiting from low fuel prices, Delta's 20%-21% operating margin should put it near the top of the pack among the major U.S. airlines.

More good times ahead
Delta is likely to continue its path of solid margin expansion in the next few quarters. In addition to the ongoing impact of low fuel prices, Delta will also benefit from significant capacity cuts it is making on international routes to address the negative impact of the strong dollar.

Delta had initially planned to increase its international capacity by about 3% during Q4. However, it made deep cuts to its fall schedule in April, targeting underperforming regions like Africa, India, the Middle East, Russia, Japan, and Brazil.

As a result, by April, Delta was projecting that its international capacity would decline by about 3% in Q4. That compares to international capacity increases of 2.6% in July and August, and a 0.7% year-over-year reduction in international capacity last month.

International capacity cuts will bolster Delta's unit revenue in the next few quarters. Photo: The Motley Fool

Delta has continued to tweak its schedule, so its international capacity could potentially decline even more in Q4 and subsequent quarters. This should allow it to make steady progress from mid-single digit unit revenue declines in Q2 and Q3 of this year to a low single-digit decline in Q4 and back to modest unit revenue growth by the first half of 2016.

Cheap as they come
Despite Delta's rising profitability, the stock continues to trade at a bargain valuation: about 10 times projected 2015 earnings and eight times projected 2016 earnings. Delta also sports a solid balance sheet that is just one notch from investment grade and it produces copious free cash flow: roughly $4 billion-$5 billion annually.

As long as Delta continues to make sensible moves to match capacity to demand and limit cost increases, it should be able to sustain today's high level of profitability. That's enough to justify a meaningfully higher stock price.

It's hard to know when the stock will regain its momentum, as the market currently seems to be irrationally pessimistic about Delta's prospects. However, in the meantime, investors can collect the 1.2% dividend -- which has jumped by 50% in each of the past two years -- while Delta shrinks its share count through an ongoing $5 billion share buyback program. This is as good a time as any for long-term investors to get on board with Delta.

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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