<p>18th-century British nobleman Baron Rothschild famously said, “The time to buy is when there is blood on the streets.” For shares in Delta Air Lines (NYSE: DAL), there is definitely blood on the streets.
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The DAL share has fallen by almost 40% in less than a month. The fear of bankruptcy swirls around. Travel bans will crush revenues and profits for 2020. Delta has already announced significant moves in response, but with the DAL share down 6.7% on Monday, it is clear that these moves have not yet reassured investors.
Contrarian-minded investors may be tempted to enter the downturn. More than a few did on Friday, as Delta shares rose nearly 14%. But this does not look like a buying opportunity. At least not yet.
There are real risks here, and a valuation that is not as cheap as title multiples suggest. It can get worse before it gets better, and I bet it probably will.
The industry’s fears return
The aviation industry is notoriously difficult for investors. Berkshire Hathaway (NYSE: BRK.A, NYSE: BRK.B) Chairman Warren Buffett infamously criticized the industry for decades after a loss-making investment in USAir, now part of American Airlines (NASDAQ: AAL).
As Buffett explained over the years, airlines are low-priced companies with relatively high fixed costs. It is and has been a recipe for disaster when times get tough. In fact, Southwest Airlines (NYSE: LUV) is the only major US airline that has never gone bankrupt.
Delta went bankrupt in 2005 before ending the process in 2007. Now there are fears that the industry’s underlying weakness will return.
Revenue will fall this year. The airline said last Tuesday that capacity will be reduced by 15%. Until Friday, the outlook was much worse: an internal memo said that capacity would decrease by 40%. Delta CEO Ed Bastian wrote that “the rate of demand on demand is different from what we have ever seen.”
Even a 40% cut is almost certainly not enough. United Airlines (NYSE: UAL) last week reported a “difficult scenario” where revenues fell 70% in April and only recovered to a 20% decline at the end of the year. Just a few days later, the scenario hardly looks awful. It can actually be conservative.
Regardless of the actual figures, revenue reductions are likely to exceed capacity reductions. And this is the problem with the industry that Buffett has long identified. When times are good, the industry shows solid, but not necessarily world-wide profits. When problems arise, however, “horrible” scenarios become reality in the short term.
The winnings are wiped out
In 2019, Delta had an impressive year. Revenue of $ 47 billion was a record. Adjusted earnings per share increased by 30% compared to the same period last year to USD 7.31.
But the figures for 2019 show the risk in 2020. During a record revenue year, in a strong economy, Delta generated $ 4.2 billion in free cash flow. That is less than 9% of revenue.
Reduce revenues by 20% and even provided costs fall, free cash flow is almost certainly wiped out. Lower fuel costs thanks to strong crude oil prices help: Delta last week estimated an advantage of $ 2 billion for the full year. (Fewer flights, however, obviously means that the benefit will be lower than expected.) Aircraft parking and freezing can also help.
Delta is still on its way to significant short-term pain and a central impact. It took a couple of years after both the 9/11 attacks and the financial crisis for passenger volumes in the industry to return to their peaks. The effect of coronavirus is expected to be similar.
Delta is unlikely to go bankrupt immediately. The company said last week that it should close this quarter with “at least” $ 5 billion in liquidity (cash plus access to loans). It can also borrow against its aircraft. The company has reduced total debt in recent years, making it better positioned than some rivals (especially US) to handle a multi-year soft patch.
The problem for DAL shares is that it is not necessarily enough to avoid bankruptcy to propose up and down for the share.
The case against DAL Stock
Even after these declines, Delta still has a market capitalization of over $ 30 billion. And there is a case that the stock is not necessarily that cheap right now.
In relation to the result, the stock certainly looks like a theft. It is traded at less than 5x adjusted EPS for 2019.
But again, this is a very cyclical business. And it suddenly looks like the result for 2019 was a peak. If this is indeed the case, the DAL share should be traded at a compressed multiple in relation to these gains.
It, too, ignores the short-lived problem: the news will get worse. Travel stocks crash across the board. There are some signs of a bottom in this market wider. Many companies with better, stronger business models and less direct exposure to coronavirus have seen their stock prices fall ~ 40% as well. I’m reluctant to necessarily choose Delta shares as the winner – at least right now.
The long-term case
That said, at some point, normality will return. And with the long view, the news for DAL shares is not quite as bad as this analysis has suggested so far.
Buffett himself actually became a boom in the industry in 2016; Berkshire Hathaway owns 11% of the company. And ‘Oracle of Omaha’ just said last week that it does not sell any of its airline stocks.
I also saw value in the industry at the beginning of the year and called the US Global Jets ETF (NYSEARCA: JETS) my choice as the best ETF 2020. It was obviously a bad conversation: JETS has been halved so far this year.
But the reason for optimism towards the industry was that rational behavior had returned. Harmful ticket wars were disadvantageous. Delta was not the only company to reduce its debt significantly. Millennial customers continue to prefer experiences such as traveling to material possessions.
The risk is now double. First, that a long-term impact will lead to financial distress, which in turn requires potentially high-level assistance from the federal government. The industry said on Monday that it was seeking $ 50 billion in such funds.
Second, the post-coronavirus economy will see a return to irrational behavior. As Buffett himself put it in 1989, the company’s raw material means “it’s impossible to be much smarter than your stupidest competitor.” During high times, the industry was smart. Will it continue in a time of struggle or desperation?
I do not think Delta will go bankrupt. I think DAL shares will accumulate, at least sometime. But an investor can not just look at a 5x subsequent price-to-revenue multiple and a short-term impact, and assume that this sale is unjustified or will end anytime soon.
Even if the coronavirus stops spreading and life returns to something close to normal in the next few months, there will be ripple effects for the industry. Meanwhile, with a market capitalization still above $ 30 billion, a significant debt burden and problems ahead, the short-term bottom is not necessarily for DAL stocks.
Vince Martin has been covering the financial industry for nearly a decade for InvestorPlace.com and other stores. He has no positions in any of the mentioned securities.