Navigating the Skies of the Airline Industry

by Overheard Wall Street
  • Intro
  • History
  • Universe
  • Delta
  • Conclusion/Recommendation

Intro

It’s safe to say airlines have had a rough go of it during the 2020s. Just when the industry was all ready to take off into the 2020s with high hopes and a full tank of fuel, the Covid pandemic left most of their planes grounded.

But just when they thought the Covid turbulence was behind them, a pilot shortage and skyrocketing fuel prices took off with a vengeance in 2022, making for one wild and bumpy year.

The airline industry has become a vital part of the American economy. Commercial aviation drives over 5% of the United States' GDP - the equivalent of over $1.2 trillion. But despite being a critical component of our economy, a path to profitability isn’t always clear for the airline industry.

While American travel is starting to creep back to pre-pandemic highs (close to 3 million Americans are flying every day), the business travel industry is nevertheless struggling to rebound. The airline industry was already low-margin before Covid, so investing in the industry in 2023 might not be a slam-dunk.

History 

The airline industry as we know it today took off during the late 1970s and early 1980s. The US passed the 1978 Airline Deregulation Act which shifted the responsibility of regulation from the government to the airline industry.

The act allowed airlines to fly any route and charge any price, leading to the formation of new airlines and decreased fares. 

The bankruptcy of major airlines such as Pan American World Airways, TWA, United Airlines, and Delta Air Lines in the 1990s and early 2000s led to a focus on cost-cutting and reducing investments, including IT infrastructure. 

Some economists say the 1978 Deregulation Act resulted in poor customer service and experiences, as airlines prioritized stock buybacks over improving services. To boost profits, airlines also downsized seats and added fees for previously included services, causing planes to become increasingly crowded.

Universe

The skies have changed dramatically over the past decade, with three major airlines monopolizing the skies of the United States.

In a shocking turn of events, United, Delta, and American Airlines each gobbled up a similar-sized competitor between 2008 and 2013, leaving only two new airlines to enter the market in the past 16 years. This has resulted in the four major carriers and their affiliate regional airlines now holding a staggering 80% control of all US routes. 

Last quarter (Q4 2022), United Airlines, American Airlines, and Delta Air Lines, despite their reputation for poor customer service and cramped seating, reported a combined net profit of $2.47 billion, on a soaring revenue of $39 billion. The only exception was Southwest Airlines, which took a hit from the recent cost debacle, but still has its sights set on profits in the coming year.

It seems that even though passengers are grumbling about the flight experience, they're still eager to travel by air. With high demand for air travel and limited flight options, airlines are enjoying a boost in passenger yield - the amount of money they make per flying passenger. The airlines are capitalizing on the increased interest, with a prediction of a profitable 2023.

Here are some of the most prevalent airline stocks:
  1. Delta Air Lines ($DAL) - the second-largest airline in the world by passenger volume. 
  2. American Airlines Group ($AAL) - the world's largest airline by fleet size and passenger volume.  
  3. Southwest Airlines Co ($LUV) - a low-cost airline that operates primarily in the United States. 
  4. United Airlines Holdings ($UAL) - the largest airline in the world by revenue. 
  5. Alaska Air Group ($ALK) - a regional airline that operates primarily in the United States and Canada. 
  6. JetBlue ($JBU) - a low-cost airline that operates primarily in the United States, just bought Spirit Airlines in 2022.  

Airline Industry Bulls 
  1. Growing Demand: With the increasing number of middle-class populations and disposable income, the demand for air travel is growing, leading to increased revenue for airlines.
  2. Cost-Efficiency: Airlines have made significant strides in reducing costs through technology, fuel-efficient aircraft, and streamlined operations. This has led to increased profitability and improved financial stability.
  3. Infrastructure Investment: The investment in new airports, air traffic control systems, and air-travel-related infrastructure is creating opportunities for airlines to improve operations and expand their reach.
  4. Government Support: Governments around the world are providing incentives and subsidies to the airline industry, helping to lower operating costs and increase profitability.
  5. Low Interest Rates: Airline Alliances: Airlines are forming alliances to offer more convenient travel options, increased route coverage, and better pricing, attracting more customers and increasing revenue.

Bears
  1. Volatility: The airline industry is highly susceptible to economic fluctuations, natural disasters, geopolitical tensions, and other events that can cause sudden, drastic changes in demand and prices.
  2. Competition: The airline industry is extremely competitive, with many companies fighting for market share, making it difficult for individual airlines to maintain a strong market position.
  3. Regulation: Air travel is heavily regulated, which can make it difficult for airlines to navigate the complex web of laws and regulations governing air travel, including environmental regulations, safety rules, and antitrust laws.
  4. Labor costs: Labor costs make up a significant portion of an airline's operating costs, and labor unions can be a source of ongoing tension and conflict between management and employees.
  5. Fuel costs: The cost of fuel is a major factor in the airline industry, and it can be subject to sudden, large price swings that can impact the financial performance of individual airlines.
  6. Environmental concerns: The aviation industry is facing increasing scrutiny and pressure to reduce its carbon footprint and other environmental impacts, which could result in new regulations, taxes, or other costs that could impact the bottom line.
  7. High Interest Rates: With interest rates at historically high levels, the cost of borrowing money for airline investments is higher, making it an unattractive investment opportunity.
  8. Debt load increase and share dilution for a lot of airlines during the pandemic will prevent the price from returning any time soon.

 Delta 

For today’s write up, we will be doing a deep-dive on Delta, which is typically the highest-rated US airline from both a customer-service perspective as well as key industry metrics such as cancellation and on-time rate.

Delta’s stock is still battered from its pre-pandemic 2020 highs. As the company pays off debt it accrued during the pandemic, we believe Delta represents a compelling investment opportunity for investors seeking to capitalize on a well-positioned, financially strong airline with a promising outlook for future growth and profitability.

Delta is to the airline industry what Chick-Fil-A is to fast food. Both are based in Atlanta and bring Southern hospitality to industries Americans loathe.

As a result, Delta has amassed a ‘cult following’ of sorts, similarly to Chick-Fil-A. 

A unique aspect of Delta is that the company also makes money from operating its own oil refinery business. Delta uses its oil refinery business to provide jet fuel to its aircraft. It is unique for an airline like Delta to manage the entire jet fuel ecosystem, from operating the oil refinery to ultimately putting jet fuel into its own aircrafts.

Delta Air Lines is set to soar to new heights in the financial stratosphere with projected earnings for FY23 reaching for the sky and expected to nearly double. The airline giant has flexed its financial muscles, displaying unwavering resilience in the face of turbulence caused by the pandemic. 

Delta’s expectations for FY23 earnings to nearly double and free cash flows to exceed $2 billion. The company has demonstrated impressive resilience in the wake of the pandemic, with a focus on restoring its balance sheet to investment-grade metrics, driven by strong cash flows across its business segments. Despite an underwhelming Q1 outlook, Delta is well-positioned to efficiently regrow its capacity, and has reaffirmed its guidance for 2023.

Delta is also poised to see a significant upside as oil prices are expected to drop in 2023. A drop in oil prices could boost Delta’s profitability and cash flows to their highs in September 2019.

Delta’s management of an oil refinery could also be a double-edged sword and make some investors bearish. Like airlines, oil refining is a cyclical business that can be expensive to run and low-margin even in the best of times. Oil refineries are also subject to government regulations.

Delta Air Lines has a strong market position, serving a diverse range of destinations across the globe and offering a broad array of products and services that meet the needs of a variety of travelers. The company has also demonstrated a commitment to innovation, investing heavily in new technologies and services that enhance the customer experience.

Delta Bulls
  • Brand Recognition/Customer Satisfaction
    • Delta has some of the most positive brand recognition in the airline industry, and with that comes a strong ‘cult-like’ following and a high passenger retention rate.
  • Growth/Innovation
    • Delta is investing in new technologies and services that not only enhance the customer experience but also reduce flying costs.
  • Undervalued
    • Delta seems to be undervalued (P/E: 7.6x) compared to industry peers (P/E: 11.7x). Delta accrued significant debt in the pandemic and if it is able to pay off debt in a timely manner, like it has been, it could bring Delta's valuation more in line with peers.

Delta Bears
  • Exposure to Refinery
    • Delta has significant exposure to the oil industry as it owns a refinery outside of Philadelphia. With oil prices decreasing, Delta could see an impact on its bottom line. For example, Delta’s refinery lost $114 million in Q2 2020 the last time oil prices crashed. Some investors think the liabilities of owning an oil refinery outweigh the pros.
  • Airline Industry Shocks
    • Like its peers, Delta is low-margin and subject to shocks such as pilot shortages and high fuel prices. While most industry experts think Delta is a well-run company, Delta is still susceptible to some of the industry’s pitfalls.

 Conclusion/Recommendation

As the world continues to recover from the impact of the pandemic, the airline industry faces a new reality. The shift towards virtual meetings has reduced the demand for costly business travel and airline add-ons, leading to skepticism about the industry's future prospects.

However, amidst these challenges, Delta stands out as a potential opportunity for investors. The market seems to be undervaluing the airline, despite its resilience in the face of industry volatility and low-margins.

Now may be the time for investors to consider joining Delta as it strives to regain its pre-pandemic heights. Despite the challenges, Delta offers a chance to be part of a company that is working to navigate a complex market and deliver value to its customers and investors.

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