What if I told you about a company that was earning all-time record profits, had paid its net debt down to less than one times its pre-interest, pre-tax profit and had massively improved its return on capital (20%+) to well above its cost of capital (9%)? This very same company has solid management, correctly incented on return on capital, who returns significant capital to shareholders through share repurchases (and actually does more at lower levels, gasp!) along with a newly issued dividend that has more than doubled over the past two years.
Where should a company like that trade? I’ll give you a hint, it’s an industrial company. Should it trade at a 5% free cash flow yield like the average S&P industrials? Would it be a bargain if it’s free cash flow yield were 50% higher or maybe 100%? Well, it’s actually well over 100% higher. This company, Delta Airlines, trades at a 12% free cash flow yield.
We have been owners of the airlines for years due to industry consolidation that appears to have led to a more economically rational management and thus better economics. Incentives are always crucial, so the importance of the shift to compensation based on return on capital can’t be understated. We own three airlines, Delta Airlines, American Airlines and United Airlines. Each one reported record profits in the most recent quarter. American’s CEO, Doug Parker, recently opted to be paid entirely in stock. To be clear, this means he doesn’t get paid unless we get paid. We like that.
So why are all the stocks down this year? Normally, one would think that when the commodity input (oil) that makes up the largest component of a company’s cost structure declines 19% year-to-date (and 52% over the past year), that would be a good thing. It has been for profits.
The reasons cited for disappointing performance are declining PRASM (passenger revenue per available seat mile), a measure of unit revenue, expectations for a reversal in crude, competition on some routes and recent Department of Justice (DOJ) and Senate investigations. After three consecutive years where our airlines were up 80% per year on average versus the S&P 500’s 20% average annual gain, a pullback doesn’t surprise us.
Some of the fears are more concerning than others, but overall we still remain confident in the airlines. The value of the business is the present value of the future free cash flow. This is true even for airlines even though barely anyone uses discounted cash flows to estimate value. One Wall Street analyst did so for the first time recently and came up with values much higher than the current price. Unit revenues, input costs and competition all matter to the extent that they impact the cash flows. These items usually do ultimately have some effect, but not always. For instance, if the companies continue to grow capacity, unit revenues can fall while overall revenues still rise (along with profits and cash flow). Another example of how current bearishness is overstated: movements in the dollar and oil highly correlate inversely. So it’s highly likely wrong to assume oil prices rebound significantly while the dollar remains strong hurting international route profitability. Yet that’s exactly what most analysts assume.
Even factoring in rising fuel prices, consensus forecasts rising profits next year (unfortunately, there aren’t many free cash flow estimates, but profits correlate better than other line items further up the income statement). We agree that we haven’t yet seen peak profits or cash flows. So we believe that a 12% free cash flow yield with growing cash flows is a great bargain.
Airlines remain a cyclical industry, but improvements in industry structure should dampen the impact of the cycle. Debt pay down alone will vastly improve trough earnings. Delta’s net debt burden has fallen from $17B in 2009 to $6B and is heading for $4B next year, according to the company. The last recession was the most severe we’ve experienced since the Great Depression, yet excluding interest expense and modest restructuring expenses from its recent merger with Northwest, Delta would have been profitable. It will still have a few hundred million in interest expense but we believe the improved industry structure gives it a good shot at maintaining profitability next time around.
The stocks have actually begun acting better recently. Earnings revisions have ticked up. We have seen upward earnings revisions correlate with the bottom in other names, like Apple, as people want to time things perfectly in this market. Regardless of whether that’s the case this time, we continue to believe there’s significant upside in the airlines at these prices.
The views expressed are subject to change at any time. LMM disclaims any responsibility to update such views. The presentation should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee the views expressed will turn out to be correct.
©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.