Delta Air Lines: No Indications It Will Fall Victim To A Recession

Investment Thesis

Delta Air Lines (NYSE:DAL) released an updated financial outlook last week, which suggests a nearly two-fold increase in adjusted EPS in FY23 and free cash flows of more than $2 billion. In this article, I highlight the catalysts responsible for these impressive metrics as well as outline the reasons behind why the airline is my top investment pick for 2023.

Emergence of The Bleisure Traveller Has Been a Blessing

The airline industry, post-COVID, has a new form of consumer to cater to: The Bleisure traveller. According to the Wall Street Journal, a Bleisure traveller is one who travels on strange days, buys extra perks on top of already expensive tickets, and is changing the economics of the travel business. Driven by the shift to a hybrid working environment and the pent-up urge to travel developed as a result of the pandemic, there has been a surge in demand for extra legroom and other flying perks. And Delta has been thriving on this demand.

Premium has led Delta’s recovery since COVID and the expanding premium revenue has allowed the airline to continue to put more premium seats into the marketplace. 55% of the airline’s overall revenues, today, is generated from premium products and non-ticket sources. By 2023, DAL expects this figure to rise to nearly 60%. The airline now expects nearly 15,000 more daily premium seats in 2023 compared to 2019 and premium economy is expected to represent nearly 30% of the total seats available.

The increasing “premiumisation” of flying, both domestically and internationally has enabled Delta to boost its top and bottom lines even in the absence of 100% capacity and even as corporate travel, one of the biggest revenue drivers for the airlines, continues to lag the pre-pandemic levels.

Renewed Focus on Cost-Reduction Should Allow Delta to Weather the Recession Storm

Delta, in the financial update, also outlined its plans of driving down costs in the coming years. More specifically, by summer of 2023, the airline plans to have to 30 to 40% of its total fleet comprised of new-generation airplanes that have lower fuel burn, which should result in a lower cost structure for the airline.

Moreover, the airline hired over 25,000 people in FY22, which resulted in over $1 billion of excess costs. The airline is now expected to shift its focus from training new members to putting the new hires into operation, which should further drive down costs. In addition, the airline now expects non-fuel costs to come down by 5 to 7% year-over-year, which it attributes to improved efficiencies and a substantial reduction in the rebuild costs.

Delta now expects the operating leverage, obtained via the aforementioned moves, to more than offset the inflationary pressures coming in from the supply side. Overall, the combination of fleet renewal and the reduction in rebuild costs as well as other sources of improved efficiency is expected to create a 10 to 12% increase, year-over-year, in Delta’s FY23 operating margins. To put things in context, that’s double the airline’s FY22 margins.

Continued Opportunities to Diversify Revenue Bodes Well for Delta’s Future

Finally, the revenue diversification process undertaken by the airline should also contribute to its future growth. Delta is expected to prioritize revenues from cargo operations in the coming years. The replacement of the existing 767s with the A330s should help with this goal since the latter has higher cargo capabilities compared to the former.

Furthermore, there’s the partnerships that Delta has made with the likes of American Express, Starbucks, Instacart, and Lyft, which is providing a significant boost to the airline’s SkyMiles loyalty programme. For instance, the co-brand spend from American Express is up over 40% from 2019 levels and the contribution from AmEx is expected to be close to $5.5 billion in FY23.

Overall, the added revenue boost from these partnerships will be a growth catalyst for the airline in the coming years.

Valuation

Click to enlarge

Source: Company’s Financial Update, Refinitiv, and Author’s Calculations

The stock, according to Refinitiv, is currently trading at a forward P/E of 6.34x, significantly below the industry median of 8.45x. I am of the opinion that Delta should be trading at the median level, given its consistent performance and the growth catalysts highlighted above. Therefore, I have assumed a forward P/E of 8.45x.

The company now expects EPS to come in between $5 and $6. I have assumed the lower end of the company’s updated guidance, i.e., $5.

Therefore, assuming a forward P/E of 8.45x and assuming an EPS of $5, we get a price target of $43, which represents an approximate 28% upside from the closing price on 21^st December 2022.

Risk Factors

With an impending economic slowdown looming, there is the possibility of a rapid destruction of consumer demand despite consumers’ existing strong appetite for travel. The airline industry is extremely susceptible to any form of slowdown, recession or not, and this aspect remains unchanged despite the surge in demand.

Furthermore, while the pace of Delta’s debt reduction has been impressive, it’s important that the airline continues to sustain it. In the event of a slowdown, sustaining the debt reduction might not be possible, which is likely to cause some degree of restlessness amongst investors, given that the airline has a debt/equity ratio of 506%.

Finally, the updated guidance provided by the airline assumes that the current agreement with the pilots’ union will be ratified. Any adverse developments in this area can cause further headwinds going forward.

Concluding Thoughts

In short, Delta Airline continues to mesmerize investors with consistent growth despite the challenging headwinds. With FY23 EPS and operating margins expected to nearly double year-over-year, the renewed focus on cost reductions, and the continued strength in the airline’s partnerships with top brands suggests that the airline continues to remain in top shape.

However, for me, it’s the emergence of the Bleisure Traveller that is going to drive the airline’s growth for the foreseeable future via “premiumisation” of the airline. Bleisure travellers have boosted the demand for premium products, both domestically and internationally.

While the impending slowdown in the U.S. economy will likely test whether the demand from Bleisure travellers is sustainable or not, as things stand, this demand remains robust. As such, it looks like clear skies ahead for my top investment pick of 2023!

Editor’s Note: This article was submitted as part of Seeking Alpha’s Top 2023 Pick competition, which runs through December 25. This competition is open to all users and contributors; click here to find out more and submit your article today!