In the backdrop of a worsening spread of the coronavirus, severely depressed air travel demand, and enormous losses in the airline business, what’s to like about a company like Delta Air Lines (DAL) that has just reported a whopping 90% revenue decline and a horrific net loss of $5.7 billion in the second quarter? As dire as the situation may sound, Delta has acted swiftly to raise liquidity and cut costs in the backdrop of historic financial support by the U.S. government. In this article, I will go through the details of Delta’s recent developments and explain why I think this legacy carrier is favorably positioned to survive the pandemic and generate long-term values once the world returns to normalcy.
Pillar #1: Ample liquidity to survive for 19 months
Since the crisis took place in late March, Delta has acted decisively to raise approximately $15 billion in the capital markets at a blended interest rate of 5.5%. Besides issuing notes, drawing from credit facilities, and entering into sale-leaseback transactions, Delta has also amended credit facility covenants, postponed voluntary pension funding, and slashed dividends and buybacks. At the end of Q2, the company had $15.7 billion in total liquidity, including $4.9 billion received from the CARES Act. Assuming no improvement in the current cash burn rate of $27 million a day, this represents 19 months of liquidity that could last until January 2022.
A check on Delta’s bond price can quickly reveal how confident bondholders are in the company’s ability to service its debt. Having briefly dropped below 80 cents on the dollar in late March, Delta’s bond now trades near par. Since the bond market is driven by conservative investors who keep a close eye on their principal and interest, the perceived solvency risk of Delta is evidently lower. Aside from a highly accommodative interest rate environment, the swift recovery of Delta’s bond price can also be attributed to the Federal Reserve’s unprecedented support for the bond market.
At June 30, the total amount of Delta’s debt and finance lease stood at $24.7 billion. Against $8.7 billion of stockholder equity, this equates to a debt-to-equity ratio of 2.84 and a debt-to-capital ratio of 0.74. As concerning as this may seem, Delta has actually been through worse. After merging with Northwest, Delta was a highly leveraged enterprise with a capital structure that’s financed almost entirely with $17 billion of debt in 2009. Within the next decade, however, Delta grew sales, cut costs, improved operating profits and reduced leverage. Between 2009 and 2019, revenue increased from $28 to $47 billion while total debt decreased from $17 to $11 billion. Although the past isn’t a perfect predictor of the future, it does show that Delta has a history of emerging from a financially challenged situation.
One thing that sets Delta apart from competitors such as Southwest (LUV) and United (UAL) under the impact of COVID-19 is management’s determination to raise capital without diluting shareholder interest. In fact, none of the $15 billion Delta has raised thus far contains any convertible feature that would potentially increase the current shareholder base. At the end of Q2, Delta had roughly $6-7 billion of unencumbered assets, excluding its SkyMiles data. Assuming an LTV of 60%, this would translate into $3.6-4.2 billion of additional, non-dilutive liquidity that can be used to address various maintenance capital expenditures and operating expenses during the crisis.
All told, Delta has built a solid balance sheet over the last decade and there’s plenty of ammunition left in this apocalyptic environment. Of course, the road to recovery will be choppy as per management and the company certainly cannot raise debt forever. Therefore, this leaves expense management a highly critical factor in determining Delta’s survivability.
Pillar #2: Significant improvement in cash burn
When the crisis began, Delta was burning $100 million a day in late March. Today, the burn rate has been significantly reduced to $27 million a day. According to management, most of the improvement resulted from a slow-down in ticket refunds in May and net sales trending positive in June. Since the majority of refunds were pre-booked summer tickets to transatlantic and international destinations, management expects these cash outflows to stabilize going forward. Of the $27 million cash burn per day, $10 million is attributable to Delta’s international operation while $17 million comes from domestic.
Besides slowing refunds and stabilizing sales, Delta’s expense management was also a key contributor to the improvement in cash burn. For Q2, Delta reduced its operating expenses by 50% and is looking to do the same for Q3. This is a result of the following actions:
- Retiring more than 100 aircraft including the entire MD-88, MD-90, 777 and 737-700 fleets.
- Offering voluntary unpaid leaves from 1 to 12 months, which more than 45,000 employees have taken.
- Offering early retirement and separation programs with most departures starting from August 1, for which 17,000 employees have signed up. Management estimates a $2.7-3.3 billion charge for these programs in the September quarter.
- Reducing salaries for officers and directors by 50% and 25% and reducing work hours by 25%.
- Implementing a hiring freeze, delaying non-essential maintenance costs, and cutting other discretionary spending such as advertising.
Given reduced consumer demand, Delta’s fuel expense was $2 billion lower than last year’s and the company saved roughly $250 million from parking more than 700 aircraft. These variable costs made up about 40% of the $5.5 billion decline in operating expenses in Q2. Though Delta has eliminated some fixed costs by retiring older fleets and offering early retirement, expenses related to aircraft fuel, passenger service, commissions, and regional carriers will eventually come back as demand returns.
Per management, the $27 million daily cash burn is expected to reduce down to zero by the end of 2020. About $5 million of the improvement will come from refunds winding down as Delta has issued a total of $2.1 billion in refunds by Q2. The remaining $20 million, management believes, will come from a gradual return of net sales. Therefore, it seems as though Delta has already done its best at optimizing the cost structure, so consumer demand will play a critical role in the company’s cash flow going forward.
Pillar #3: Historic government intervention
The most immediate response I hear from people about an investment idea like Delta is the high probability of bankruptcy in a minimal revenue environment like this. While I think this is largely true since many airlines from Norwegian Air (OTCPK:NWARF), Virgin Australia (OTC:VBHLY), Avianca (OTCPK:AVHOQ), Aeroméxico (OTCPK:GRPAQ), to LATAM (OTCPK:LTMAQ) have already filed for Chapter 11, one key factor that differentiates the U.S. aviation industry from the rest of the world is the remarkable level of government intervention that provides up to $50 billion of financial support to airline companies through the CARES Act.
On the receiving end of this unprecedented government program, Delta is eligible for $5.4 billion from the Treasury Department which includes the following:
- $3.8 billion in direct payroll grant under the conditions of (1) no involuntary furlough until September 30, 2020, (2) no stock buybacks or dividends until September 30, 2021, and (3) certain limitations on executive compensation until March 24, 2022. On the income statement, this amount will show up as a contra expense item to offset salaries and other operating costs.
- $1.6 billion in a 10-year, unsecured low-interest rate bond at 1% for the first 5 years until April 2025 and secured overnight financing rate (SOFR) + 2% over the final 5 years. In addition, 10% or $160 million of the loan amount will be awarded to the Treasury Department as 6.5 million warrants at an exercise price of $24.39 with a 5-year term. This would dilute Delta’s current share base of ~638 million by 1%.
On top of the first $5.4 billion, Delta is eligible for another $4.6 billion secured loan from the Treasury Department. Once again, 10% of the loan amount or $460 million will have to be granted to Treasury as warrants. Assuming an exercise price of $24 a share, this will represent another 3% of Delta’s current shares outstanding, leading to a modest total dilution of 4%. To date, management has until the end of September to decide whether to take the loan, which, if accepted, will boost Delta’s current liquidity to $20 billion.
Having provided massive liquidity to the commercial aviation industry that supports more than 10 million jobs, the U.S. government essentially has a vested interest in the outcome of the challenges facing every airline company. To the Treasury Department, Delta is an asset that provides not only a regular interest income for the next 10 years, but also a generous paycheck on the 6.5 million warrants when the stock price recovers (they called it “taxpayer protection”). Therefore, I think a strong case can be made that the current administration won’t let the nation’s airlines fall that easily, though I should note that if the best scientists fail to develop a safe and effective vaccine to contain the virus, no amount of federal support can save the industry.
In sum, Delta has just reported the worst quarter in company history and guidance for the next quarter doesn’t sound too optimistic either. Business travel, which typically makes up 50% of revenue, is nowhere to be seen and will take around 12-18 months to return as per management. CEO Ed Bastian also thinks business travel is unlikely to ever come back to 2019 levels, since a two-day round trip to Europe for a meeting can now be easily replaced by technology such as Zoom.
However, one reason why this may not be the end of business travel is that humans are a gregarious bunch. Therefore, certain activities such as trade shows, exhibitions, and new customer meetings that require human interactions and relationship building will remain relevant. In my view, business is done face to face, and although Zoom does provide great convenience under the current circumstances, it’s always easier to meet someone in-person, shake hands, talk about life, relationships and hobbies, then show how your product can benefit their company.
I began acquiring shares of Delta in late April and added to my position after Warren Buffett announced his exit of the airline industry. For Delta, there’s no question that (1) demand will not fully recover until a vaccine is developed, (2) social distancing measures will be implemented at the expense of profits, and (3) interest payments will consume a significant portion of future operating income. However, I believe market participants have largely acted upon the negatives, and the ultimate exit of Buffett, in my view, was a reasonable indication that hope had mostly been eradicated.
Despite a strong gain in June (courtesy of Robinhood traders), the stock is now back to its 60-day moving average and has been completely left behind in the recent market rally powered by the tech sector. It’s true that tech is a net beneficiary of the virus, but here’s the problem: who doesn’t know that? I know this, my neighbor knows this, the Uber driver knows this, the Uber driver’s Uber driver knows this. So what does that say about the return prospects of a tech-focused portfolio? On the theory that every sector eventually has its day, I believe a portfolio tilted towards companies that could emerge from the other side of COVID-19 will perform tremendously well.
No one can argue that air travel demand will recover quickly despite the collective effort of the world’s top scientists in finding a solution. But equally, no one can argue that the current state of the travel industry (~25% of 2019 levels) will continue forever and that society will permanently give up flying in favor of other methods of transportation. As much as investors may be treading in uncharted waters, it is my view that the world genuinely wants to get better, the brightest minds in science will innovate to defeat the virus, governments will do what they can to help, and businesses will be back as usual.
Disclosure: I am/we are long DAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.