Warren Buffett Bets on Delta Air Lines Again
Airline stocks are among the most beaten-down stocks in the market amidst the spreading of the new coronavirus. If an investor had to take a wild guess as to which legendary investor might be buying stocks in this sector, many would undoubtedly agree that it should be Warren Buffett (Trades, Portfolio). This is because of his track record of investing in unloved companies when the outlook seems gloomy in the minds of retail investors.
According to GuruFocus data, Berkshire Hathaway Inc. (BRK.A) owned approximately 11% of outstanding shares of Delta Air Lines Inc. (NYSE:DAL) at the end of 2019, and a Form 4 document submitted to the Securities and Exchange Commission (SEC) on Monday reveals that Buffett increased his stake in Delta on Feb. 27.
Source: SEC website
The average purchase price, as illustrated above, has varied from $45.4798 to $47.1442. In contrast, the current market price of Delta shares is $47.16 on Tuesday at the time of writing this article. As a popular advocate of the margin of safety concept introduced by Benjamin Graham, Buffett's estimate for Delta's intrinsic value should be significantly higher than this price.
Understanding the dynamics driving airline stocks
Before diving deep to determine whether Delta Air Lines stock is undervalued, it's important to understand a few factors that drive the share price of companies operating in this industry. The demand for this cyclical sector is positively correlated with global GDP growth as improving economic conditions promote higher business and leisure travel. According to economics theories, luxury goods and services have a positive income elasticity of demand. This is a possible reason why consumers tend to increase their travel activities when household income rises.
Source: Intelligent Economist
Even though the Covid-19 virus will impact economic growth negatively in the first half of this year, many renowned institutions, including the World Bank, International Monetary Fund and the Federal Reserve, project a surge in trade and business activities in the second half of this year. The Organisation for Economic Co-operation and Development cut its global growth projections for 2020 by 50 basis points on Monday to 2.4%. However, none of the major economists believe that a recession is on the cards anytime soon, meaning positive numbers can be expected in the next couple of years as well. This is not a bad set-up for airline companies.
Second, the outlook for oil prices needs to be assessed to project operating margins for airline companies. The International Air Transport Association (IATA) believes that jet fuel costs across the industry will decline from $188 billion in 2019 to $182 billion in 2020, primarily as a result of lower crude oil prices. In addition, hedging activities are also expected to play a role in this $6 billion decline in fuel costs. This assumption is made on the back of an average Brent crude barrel price of $63. However, on Tuesday, Brent traded for just $50.36 as recession fears led to a drastic drop in energy prices in the last three weeks. Under these circumstances, the projections of the IATA appear to be conservative. The expected savings will translate to higher earnings for the industry, which is a positive development amidst this carnage.
Third, the interest rate environment of a country could positively or negatively impact the earnings of the industry. Because many airline companies are highly leveraged, an uptick in rates will impair their earnings power. However, the Fed funds rate is at historic lows, and an increase is highly unlikely this year. The Federal Open Market Committee has decided to cut its main policy rate by 50 basis points on Tuesday in a bid to revive economic growth amidst the growing fears of a global pandemic. This macroeconomic environment is supportive of the airline industry as well.
A thorough evaluation of industry dynamics reveals that higher profits can be expected from airline companies in the future, even though there would be a shock to revenue in the first half of 2020. This, however, will likely be short-lived, the same way it was during SARS and Ebola outbreaks. With this backdrop, it's easy to understand why Delta Air Lines is significantly undervalued.
The numbers tell the story
The conclusions drawn in the previous segment of this analysis suggest that the drastic drop in Delta share prices irrational.
Source: GuruFocus
An investment decision, however, can only be reached after evaluating the prospects for the company.
Embry-Riddle Aeronautical University named Delta Air Lines as the best carrier in the United States in its annual report for 2019. Four key factors were considered by economists at the university to rank companies.
On-time percentage
Denied boardings
Mishandled baggage
Customer complaints
Below is the ranking table for 2019.
Ranking | Company |
1 | Delta Air Lines |
2 | JetBlue Airways |
3 | Southwest Airlines |
4 | Alaska Airlines |
5 | Hawaiian Airlines |
6 | United Airlines |
7 | Spirit Airlines |
8 | American Airlines |
9 | Frontier Airlines |
Source: Embry-Riddle Aeronautical University
A noteworthy observation is that Delta was ranked as 15th out of 18 carriers in 2009 but has quickly climbed the ladder to be number one in the United States. This goes on to reveal the effectiveness of the policies implemented by the company in the last decade and the prudence of the management, which are both qualities that Buffett welcomes.
In the fourth-quarter earnings call, the management emphasized the importance of continuing to focus on providing an unmatched experience to its customers, which, in return, can lead to customer loyalty. This approach has served the company well in the last few years, and the plan is to build on that success.
There's a focus on building strong partnerships with renowned consumer brands as well, such as American Express. In the Investor Day presentation in December, the management unveiled a plan to earn more than $7 billion from its American Express partnership, which would be a significant improvement from what it earned in 2010.
Source: Investor Day presentation
Delta Air Lines is addressing the environmental challenges head-on as well. On March 2, the company announced a $1 billion plan to become the first carbon-neutral airline in the world by 2030. Even though this might not mean a lot to investors at present, the failure to embrace new regulatory standards might lead to hefty fines in the future. The company is positioning itself to avoid these costs, which is a positive sign for investors.
Even though the prospects look promising and the company is on track to deliver a strong financial performance in the next five years, shares are trading at a price-earnings ratio of 6.46, which is considerably lower than the average multiple of 11.64 in the last five years and the sector median of 19. It seems irrational that one of the best airline carriers is trading at a significant discount to its industry and historical multiples. This creates an attractive opportunity for investors to pounce on, and Buffett has already done so in the last week. The undervaluation becomes more visible when popular growth metrics for the company are compared with its peers.
Profitability metric (year-over-year growth) | Delta Air Lines | Sector median |
Revenue | 5.78% | 3.96% |
EBITDA | 17.54% | 3.15% |
EBIT | 21.82% | 2.11% |
Earnings per share | 28.75% | 4.66% |
Operating cash flow | 20.12% | 12.30% |
Source: Reuters
It's clear that Delta has grown at a much faster pace than its competitors and peers in the last 12 months, but shares are yet to reflect this performance. This anomaly has pushed shares into undervalued territory.
Takeaway: follow Buffett's lead
It's not every day that investors get an opportunity to bet on a company at or below the price Warren Buffett (Trades, Portfolio) does. However, such a unique opportunity exists with Delta Air Lines. Shares are trading at a deep discount to its fair value from a relative valuation approach and in comparison to historical multiples. At the market price of around $47.60 on Tuesday, the dividend yields 3.41%, which is an added compensation for investing in this undervalued stock.
Disclosure: I do not own any stocks mentioned in this article.
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This article first appeared on GuruFocus.
