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We're Increasing North American Airline Valuations as Industry Recovery Looks Ready for Take-OffWe're Increasing North American Airline Valuations as Industry Recovery Looks Ready for Take-Off Burkett Huey Equity Analyst Analyst Note | by Burkett Huey Updated Mar 24, 2021 After reconsidering our assumptions on the effects of COVID-19 on our North American airline coverage, we’re raising our fair value estimates for all firms we cover. We’re increasing our fair value American Airlines to $18.50 from $14, for Delta to $58.50 from $43, for Southwest to $63 from $47, for United to $55 from $41, and for Air Canada to CAD 29.50 from CAD 20. Overall, we aren’t seeing compelling value in any of these stocks, but Delta and Southwest remain our favorite companies and we think Delta offers the best relative valuation. We’re maintaining our no-moat ratings across the industry as airlines remain highly capital-intensive businesses that offer relatively commoditized products and quite sensitive to unpredictable events. The valuation update is a function of an improved near-term demand outlook that improves our capacity utilization assumptions, updated assumptions on tax credits from net operating losses, and a more favorable net debt position. Broadly, we’re anticipating that vaccinations and an easing of travel restrictions will allow substantially more domestic leisure travel over the summer of 2021, but that airlines will increase supply faster than demand rebounds, which will lead to a second year of operating losses for airlines in 2021. We anticipate that high-yielding relationship-driven business travel will return, but that some lower-yielding forms of business travel such as intercompany meetings for lower-level employees may be permanently displaced by videoconferencing. Overall, we’re anticipating industry revenue passenger miles will grow by 8% cumulatively from 2019-2025, slower than the 18% of cumulative RPM growth from 2013-2019. That noted, the fracking boom, which structurally reduced oil prices and allowed airlines to be profitable at cheaper fare levels, occurred over the 2013-2019 cycle and we think the one-time reduction in prices obscures cyclical comparisons. Business Strategy and Outlook | by Burkett Huey Updated Mar 24, 2021 We think Delta is the highest-quality legacy carrier because it has been able to attract high-yielding business travelers through its product segmentation and credit card partnerships, primarily with American Express. Delta’s 5-cabin segmentation strategy allows high-spending travelers to purchase more luxurious options when they can. Frequently, business travelers use miles from a cobranded credit card to upgrade flights when their company is unwilling to pay a premium price. American Express pays top dollar for the miles given to these business travelers, as Delta-cobranded cards alone account for about a fifth of American Express’ loan book. We’re confident that Delta can continue growing this higher-margin business after the pandemic. In the leisure market, we expect Delta will continue to receive pressure from low-cost carriers. While we believe that Delta’s basic economy offering effectively serves the leisure market, we don’t expect the firm to thrive in this segment. We’re expecting a leisure-led recovery in commercial aviation, reflecting customers increased willingness to visit friends and family and vacation in a pandemic relative to business travel. We expect that Delta will continue to target high-yielding business travelers, though we anticipate that the business travel market will be difficult for the time being. Delta’s frequent flier program consistently generates more loyalty revenue per dollar of lower-margin passenger revenue, which we think is indicative that the airline is generating substantial engagement with its platform. The COVID-19 pandemic presents airlines with the sharpest demand shock in history, forcing airlines to reduce most of their capacity and the aircraft that are still flying are flying at low load factors. We estimate that roughly half of Delta’s operating costs are fixed in the medium term and expect negative operating leverage to lead to near-term losses across the industry. We think that Delta is well-positioned to withstand the COVID-19 pandemic, but that its strategy of extracting value from business travelers will be challenging in a lower fare environment that focuses on serving leisure travel. Economic Moat | by Burkett Huey Updated Mar 24, 2021 We do not believe that Delta has earned a moat, but we think that U.S. based airlines have structurally improved their business model. Airlines have traditionally been an industry where a no-moat rating is almost too generous, with an infamous history of value destruction as measured by subpar returns on capital. IATA, an international industry group, estimates that industrywide returns on invested capital have not breached 8% in the past 15 years. In our view, there are structural factors that make it difficult for airlines to generate excess returns: a mostly undifferentiated product, a tendency for irrational competition, substantial operating leverage, and a tendency to employ financial leverage that exacerbates booms and busts. We believe that the U.S. based major airlines have structurally improved their business model through consolidation that reduces, but not eliminates, the potential for irrational competition and through attractive partnerships with banks on their frequent flier program. We do not think that these improvements are enough to dig a moat for three major reasons. First, the firm’s airline operations remain large and capital intensive enough that we don’t expect substantial excess returns over the cycle. Second, airlines remain highly sensitive to unpredictable events that can quickly destroy value. Third, airlines have already raised quite a bit of debt capital to survive the COVID-19 pandemic, and we think the threat of company failure and major value destruction is high enough that it precludes any company in the industry from receiving a moat. Airlines have historically sold commodity goods and operated in a highly competitive market, so participants in this market have traditionally been unable to control prices or costs. Typically, the primary moat source for highly competitive companies with commodity products is the cost advantage. Durable cost advantages for industry participants are elusive because low-cost carriers and ultra-low-cost carriers’ business model is predicated on continuously driving down yields to attract customers with lower fares. Delta has historically had comparably similar costs per available seat mile excluding fuel costs to peer legacies. Much of the differences in legacy airlines’ CASM can be explained through small differences in items such as depreciation and landing fees, which we don’t think constitute a sustainable economic advantage. Delta has historically captured a premium yield relative to peers, due to its focus on business travel and premium products and has received the highest yield among legacy airlines for the past nine years. We do not believe this is evidence of a major intangible asset, and that it is more due to a higher mix of higher-yielding business travelers relative to peers. As business travel is highly cyclical, we expect that this advantage is difficult to maintain in a distressed economy. We think that the frequent flier programs are essentially a capital-light business with the potential for intangible assets and switching costs attached to a capital intensive, highly competitive airline business. Intangible assets would come from the long-standing and contract-based relationships that airlines have with credit card companies to sell frequent flier miles. Switching costs would come from being the sole provider of a currency, frequent flier miles, that credit card holders find valuable. The switching costs would specifically be due to credit card companies facing difficulties in providing their customers with rewards cardholders want. At this time, we do not have enough certainty that the core airline business has escaped its long-running tendency to destroy value in normal times and we do not have enough certainty in the sustainability of returns from the capital-light frequent flier program to grant any airline a moat. Fundamentally the business of frequent flier programs can be simplified to airlines are selling miles to banks. Airlines recognize revenue from selling miles to credit card companies on the frequent flier programs in four ways. First, through marketing revenue, which represents the difference between the selling price of the mile and the redeemable value of the mile. We view this revenue as almost entirely incremental to the airlines and think that a 90% margin on this revenue is reasonable. Second, there are non-travel awards (which generally account for a small fraction of awards redeemed) such as baggage, priority boarding, and lounge access, which we assume a 70% margin on. Third, there are travel-related awards, which we conservatively assume have a similar margin to the rest of the passenger revenue, although we have reason to believe that a material proportion of these awards are used to upgrade existing travel, which would be a higher margin transaction than new travel. Finally, there is breakage revenue from miles that do not go redeemed. We estimate that the loyalty programs have operating margins in the 35%-45% range and constitute a significant proportion of operating income for the airlines. The economics on this program are quite attractive, and one might wonder why banks would be willing to pay 2-3 times the redeemable value of a mile and how sustainable these attractive agreements are. We think the Delta-American Express cobranded card is a great example of the value airlines provide to cardholders. American Express has built its brand around serving the higher-spending business traveler, and Delta’s 5-cabin segmentation strategy revolves around offering premium products to higher-spending customers. These cobranded cards that allow business travelers to rack up frequent flier points, save on baggage fees, receive priority boarding, gain access to airport lounges, and receive complimentary upgrades on flights that have not had full first-class bookings. Providing additional comforts to travelers is proving to be a very popular currency among business travelers. The cobranded Delta cards represented approximately 8% of American Express’ billings and approximately 22% of the firm’s loan portfolio in 2019. Delta’s loyalty revenue was roughly 20% of American Expresses’ cardmember reward and business development expense in 2019, which may seem like a hefty price, but American Express was eager to extend the relationship until 2029. Delta cobranded cards have been noted as a growth driver in American Express’ 10-K from 2015-2019 and Delta awarded considerably more miles than it redeemed since it began disclosing mileage redemptions in 2017, which we believe is indicative that it is still growing fairly quickly. Delta generates the highest percentage of high-margin revenue per each dollar of lower-margin passenger revenue relative to peers, which we think makes the program the most efficient. In terms of the sustainability of these businesses, the driving forces behind mileage sales are new card openings and spending on cards. While Morningstar anticipates continued growth in credit card spending and anticipates that fees to merchants as a proportion of credit card spending will remain reasonably constant, benefits from new card openings are not sustainable over the long term. We view this as a solid business going forward, and while we aren’t anticipating 2015 margins to return any day soon, we think that U.S. airlines will continue earning the lion’s share of global airline profits. The coronavirus crisis has presented the industry with its sternest test in history. Peak year to trough year capacity declines of midsingle digits after 9/11 and the 2009 financial crisis pale in comparison to the nearly 50% industrywide capacity declines we’re projecting in 2020. Previous recessions invited consolidation, allowing remaining firms to continue growing, but we do not anticipate further consolidation to be possible. While we think that COVID-19 pandemic will not change the structural improvements to the U.S. airlines, we do think this cyclical shock highlights the lack of a moat in this industry. We think the longest-lasting effects of COVID-19 on the airlines will be increased leverage and equity dilution at low prices. To survive near-term operating losses, the airlines have raised substantial capital to fund unprofitable operations. We think that this leverage is more likely than not to remain on the firms’ balance sheets for the foreseeable future because airlines do not generate enough free cash flow to take this kind of debt off the balance sheet in short order. As airlines have balance sheets that are as large as they can currently manage, we think that capital markets would be less amenable to airlines going forward, which would increase the chance of firm failure in the event of an additional unforeseen black swan event or a protracted lockdown. We think that this risk is material enough that we would hesitate to give any airline a moat rating for the time being. Fair Value and Profit Drivers | by Burkett Huey Updated Mar 24, 2021 After reassessing our North American airline valuations, we're increasing our fair value estimate for Delta to $58.50 from $43. The valuation update is a function of an improved near-term demand outlook that improves our capacity utilization assumptions, updated assumptions on tax credits from net operating losses, and a more favorable net debt position. The primary drivers of our valuation are the severity of operating losses in 2020, the pace of the recovery in air traffic, and our midcycle operating margin. Airlines faced the worst operating environment in history in 2020 due to the COVID-19 pandemic and dramatically cut capacity to respond to steep drops in demand. The worst is not quite over yet for airlines, as the COVID-19 vaccine has not been fully distributed yet, but we see a leisure-led recovery for airlines and anticipate Delta can return to 2019 levels of capacity in 2023. We expect Delta’s fundamentals will recover after a COVID-19 vaccine is distributed, which we assume will occur in 2021, and business travel subsequently resumes. We expect 2021 will be partially a continuation of 2020's operating environment and partially a recovery. We anticipate capacity will be about 69% of 2019 levels, load factors will be roughly 65%, and that yields will increase somewhat with demand. Our midcycle operating margin for Delta is about 15.7%, 20 basis points above the 2015-2019 average. We believe margin expansion from 2019 levels is reasonable because we expect high-margin loyalty marketing income will continue to grow, as loyalty revenue continues to grow from increased spending on Delta cobranded cards, and due to voluntary retirement packages during the pandemic sustainably improving the company's cost structure. We’re expecting capital expenditure will be about $2.5 billion in 2021, as Delta has deferred many of its orders from Airbus, and will average around $4 billion per year over our forecast period. We think this elevated level of capital expenditure is reasonable relative to historicals as Delta has orders to replace much of its fleet and is choosing to defer capital expenditure during the pandemic. We think an above-average cost of equity and cost of debt are reasonable for this airline. We use a lower cost of equity relative to peer legacies due to a smaller proportion of debt in the capital structure. This leads us to a 8.8% WACC. Risk and Uncertainty | by Burkett Huey Updated Mar 24, 2021 Airlines are exposed to the geopolitical risks on each node on its network, face commodity price risk from the oil market, risk of irrational competition, and general cyclical risk. The geopolitical risk is broad, as any number of unpredictable events such as wars, pandemics, international tension, and natural disasters affect travel. Fuel is airlines' second-largest cost, and we expect fuel to be a major variable cost for airlines for the foreseeable future. Delta does not hedge fuel costs and would likely face substantial margin pressures in the event of an oil price spike. Delta operates a fleet that is on the older end of peers and is particularly exposed to this risk as older aircraft are less fuel efficient. Airlines have a long history of irrational competition, due to low entry barriers and high exit barriers in the industry and a price-sensitive customer. Low-cost carriers and ultra-low-cost carriers have tendencies to enter markets and drive returns down for all participants due to an excess of supply for a somewhat fixed pool of demand. We think that the wave of consolidation in U.S. airlines after the 2009 financial crisis reduces, but not eliminates the potential for irrational competition, as there are fewer competitors to act irrationally. Air travel is generally a discretionary good that closely tracks GDP. Recessionary economic contractions reduce travel demand, which is a risk to airline investors. At this time, we do not see a way for airlines to escape cyclicality, so our fair value uncertainty is very high until COVID headwinds lessen. We see some environmental, social, and governance risk for Delta, which is largely a function of the greenhouse gas emissions from the company's operations. If carbon taxes are enacted, airlines would likely pass the cost onto the consumer, which we anticipate would reduce aggregate travel demand. At this point, ESG risk does not affect our fair value or our scenario analysis. Stewardship | by Burkett Huey Updated Mar 24, 2021 We assess the stewardship of Delta as Exemplary. This assessment was conducted using our prior Stewardship methodology. We will be transitioning our assessment mechanism for Delta and the balance of our stock coverage, to the Capital Allocation methodology by the end of September 2021. We assign an Exemplary stewardship rating to Delta due to the management’s capitalization on frequent flier programs, which have attractive economics. From a revenue perspective, legacy airlines are inherently more exposed to business travel than to leisure travel, and we think Delta has become the best at extracting value from high-spending business travelers through their frequent flier program and their extensive cabin segmentation. Delta’s cobranded offering continues to generate more high-margin loyalty revenue per dollar of lower-margin passenger revenue. We believe this is due to management’s ability to modify airline operations and selling practices to structurally improve the company’s margins, which we view as outcompeting peers and thus deserving of an Exemplary rating. In no-moat industries like airlines, we think that stewardship matters quite a bit in determining the overall quality of a firm, and we think that Delta has become a best-in-class legacy airline operator. CEO Ed Bastian has worked with the firm for over a decade and has been the chief executive since 2016. We appreciate that Delta has stuck to its aircraft acquisition strategy, mainly purchasing cheaper used aircraft but also acquiring new planes, such as the A220, at bargains. We believe these developments have created shareholder value. Delta had maintained a dividend and a share repurchase program since 2013 and had historically delivered most of free cash flow back to shareholders, but the firm has suspended its dividend in the wake of the COVID-19 pandemic. Delta has raised capital to survive 2020, but we think that the firm's strong margins, which we think is a function of Delta’s strong management, would allow the firm to survive a normal recession without raising capital. Given the highly uncertain operating environment going forward, we don’t think that airline investors should count on shareholder remuneration returning for at least the next several years. |
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