Delta: Cleared for takeoff?

by Elliott Gue, editor Energy & Income Advisor

For decades, few investors took the airline business seriously. But change is in the air.

The second-largest US air carrier, Delta Air Lines (DAL) has consistently ranked toward the top of the field in terms of year-over-year growth in revenue per available seat mile (RASM), a testament to the company’s success squeezing additional revenue out of its capacity.

Much of these RASM gains stem from the airline’s market share gains among business travelers, the industry’s highest-margin customers.

This increasing popularity among business travelers reflects a number of strategic initiatives. For one, management has sought to enhance its services at key hubs for business travelers such as New York City’s LaGuardia Airport and London’s Heathrow Airport.

Through a series of departure slot swaps with other airlines, Delta Air Lines has increased its share of departures from LaGuardia; it is also redesigning its terminal at the airport to make it more convenient for business travelers.

Management estimates that the airline poached 5 percent of the corporate market from other airlines that operate in New York City’s airports. Meanwhile, the number of SkyMiles Medallion memberships–the elite of Delta Air Lines’ frequent-flyer program–surged by 10 percent in 2012.

We also like the company’s efforts to gain market share at London’s Heathrow; this London hub accounts for 85 percent of travelers from the top 10 US markets. In fact, than 2.7 million passengers travel from New York City to London alone each year, and another 1.4 million travelers fly from Los Angeles to Heathrow.

Delta Air Lines recently agreed to acquire 49 percent of Virgin Atlantic Airlines from Singapore Airlines for $360 million. This will enhance Delta 's service to Heathrow and make connections more convenient for business travelers.

We’re also impressed by Delta Air Lines’ efforts to control costs. The carrier has taken the boldest step of its North American peers toward addressing rising fuel costs, purchasing a refinery in the Philadelphia area that’s capable of processing 185,000 barrels per day.

While the refinery promises to reduce Delta Air Lines’ fuel costs in coming years, management has also sought to improve the fleet’s fuel efficiency, by swapping 50-seat regional jets for larger aircraft that are 30 percent more efficient.

Rising revenue, fuller flights and progress on costs have enabled Delta Air Lines to generate $3.9 billion in free cash flow over the past three years, much of which has been allocated to reducing its debts.

Management expects the company to achieve its goal of reducing its net debt to $10 billion, at which point the firm will initiate a “balanced capital deployment” strategy that could involve regular dividends and stock repurchases. Such an announcement could come as early as June 2013.

Trading at 7.5 times 2012 earnings per share and about 5.4 times projected 2013 profits, the stock’s depressed valuations reflects investors’ continued bias against airlines.

With profits likely to rise at an average annual rate of 15 percent over the next three years, shares of Delta Air Lines are ripe for a higher multiple as investors rediscover this snake-bitten industry.

The stock has rallied sharply since mid-November 2012 and could be vulnerable to some profit-taking, particularly if the broader market pulls back. We’re adding Delta Air Lines to our Coverage Universe as a buy when the stock dips to less than $12.50 per share.

Learn more about this financial newsletter at Elliott  Gue's Energy & Income Advisor.