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The events of COVID-19 have touched few industries as dynamically and devastatingly as the airlines. It is for this reason that I recently began the process of reviewing the entire industry in order to better identify the companies who will lead once the inevitable resurgence in air travel demand occurs.
I began with Delta Air Lines (DAL) due to the significant decrease in market cap for a company that had possessed a strong balance sheet leading into the coronavirus-crisis. For an investor there are two questions to ask about an airline currently: do they have the liquidity to dodge Chapter 11; and who will wind up on the top of their particular market niche.
As it relates to Delta, though they compete against a number of LCC, ULCC, and Legacy airlines, their main competitors are United (UAL) and American (AAL). Southwest Airlines (LUV) rounds out the top four, which accounts for two-thirds of all passenger travel in the United States, and while Southwest is a major competitor for Delta, the lack of long-haul and spoke-and-hub operations keeps me from considering Southwest in a direct head-to-head comparison. Hawaiian Air (HA) provides long-haul routes, but is tiny in comparison to the big four, making up only 1.6% of domestic share—45% less than regional airline SkyWest (SKYW).
My main reason for isolating Delta, United, and American Airlines relates to what I believe is a fairly steady assumption: that the U.S. government will not allow all three, long-haul international carriers to go bankrupt. With a substantial portion of the bipartisan CARES act money going to the airlines, I think it is fair to assume that follow-on funds will be available to stave off severe financial distress for—at the very least—the best positioned of the big, long-haul group. If this assumption is valid, a definite floor is provided for long-term investors (I will also address short-term trading interest).
The Balance Sheet
Trying to keep up with cash has suddenly become a major headache in the airline industry. Negative cash flows have become the inconsolable theme of springtime, with forward projections representing wild guesses: there is no direct historical comparison with which to build highly reliable models on forward demand for air travel following a worldwide pandemic. The closest comparisons we have are the decrease in demand following 9/11, and the economic shock of the Great Recession. While these comparisons have obvious limitations (as neither fully captures the worldwide collapse of economic activity and fear that COVID-19 has come to represent) they also have this going for them: both are very modern examples of demand disruptions in aviation. And there is this also: we have both a fear event (9/11) and a serious recessionary event to help provide demand projections—the two conditions that the airlines are now facing.
Click the link for tables that show the percentage decline in air travel caused by both 9/11 and the Great Recession. The broad stroke is that demand rebounded to over three-quarters of pre 9/11-levels within three months of the terror attacks, and was at 90% six months later.
In the case of the Great Recession, domestic demand was 90% at its lowest point, and averaged 94% throughout the multiyear recovery (interestingly, international demand remained strong throughout the recession). If we combine the effects of the Great Recession and 9/11 as a predictor of COVID-19 air demand, two-thirds of demand would return by the end of this summer, and we would be in low to mid-eighties by the beginning of 2021. These numbers are significantly higher than most projections at the moment—and they obviously cannot completely capture the uniqueness of the coronavirus disruption—but they are provided by a strikingly direct historical review.
I discuss the potential forward effects on the economy of COVID-19 here. The quick summation is that there is still quite a bit of uncertainty regarding the path of the virus and thus the trajectory of economic recovery. Coronavirus concerns have already led to a pronouncedly deeper dip in demand than 9/11 and the Great Recession combined due to massive stay-at-home orders. The question for the airlines (and investors) is the extent to which demand will rebound over the next few months. In economic terms, how elastic is the demand for air travel? There is little question that the demand curve has shifted due to recent events. The question is this: how much do people really need to fly in today’s world?
There is no easy answer to this question, though it should be clear that air travel is a fundamental aspect of the modern world. Although Zoom (ZM) meetings have become more common during this period of economic isolation, it is not as though this technology is completely novel. Businesses travel for a reason, and those reasons have not changed: there is a competitive advantage in many cases to being in person, and in other cases the job simply cannot be done remotely.
Put it this way: would you attend your daughter’s wedding remotely? How about maintaining a business arrangement worth hundreds of thousands of dollars? Or multi-millions?
Masks, Airlines, Social Distancing at 39,000’
Enhanced security was both a boon and obstacle in the aviation resurgence following 9/11. Passengers needed to feel more comfortable with security procedures in order to assuage fears, yet the actual process of going through security was much more intrusive. Airlines are now facing a similar need to thread the needle: in requiring passengers to wear masks the hope is to reduce coronavirus induced anxiety, while at the same time not driving passengers away by a heavy hand.
Delta has set the bar among the airlines in assuaging social distancing concerns, recently announcing that booking policies would preclude selling seats beyond 60% capacity through the end of July. The net effect of this will be a higher level of flight frequency than current demand levels would normally justify. In truth, with fuel prices at low levels—and a surplus of aircraft and aircrews—the cost of the extra flights is not massive. Fuel burn and maintenance items are largely the only real cost. It is difficult to handicap the benefits to ticket sales of this policy, but there ought to be some. Whether they are sufficient to justify additional cash burn remains to be seen.
JetBlue (JBLU) responded by announcing that middle seats would be blocked through July 6th. Earlier in the month Frontier attempted to monetize the desire to socially distance: in perfect ULCC fashion, the carrier announced a $39 add-on fee if a passenger wanted to ensure that no one was sitting next to them. Swift backlash resulted in a quick shelving of the idea.
It is an unbelievably fluid situation, with completely novel ideas and policies being developed and implemented every few days. It is extremely difficult to handicap the final effect of all of these different policies, yet the desire to put customer’s minds at ease is likely to have some effect. The visible nature of enhanced cleaning, passengers and crews wearing masks, and blocked center seats, may well be enough to counteract social distancing anxieties from many of the traveling public. As long as the airlines continue to avoid being directly linked to a COVID-19 outbreak, the publicity efforts should begin to press back on the paltry demand curve.
International Investments and Delta Air Lines
With significant investments in international airlines over the past few years (designed to generate an expanded route structure via code-share agreements), Delta decided in Q1 to not impair the value of those equity positions. While the currently diminished airline environment will eventually turn around, there is little question that the Delta balance sheet is not yet reflecting the diminishing value of these assets. Given how quickly COVID-19 transpired and how uncertain future recovery trajectories are, it is understandable why Delta has not impaired these assets for now, but at some point this will have to take place.
Delta utilized the equity method of accounting, whereby impairment is not required to be recorded for temporary decreases in value, as long at Delta does not foresee the need to sell the equity at depressed market prices. Since Delta is not releasing the market data at this point, I did it for them (these calculations are at market prices on May 15th where available): according to my calculations if Delta was forced to sell off their sizable holdings of foreign airlines, they would immediately have to write off just under $1.7B from their balance sheet.
These would be gob-smacking numbers in any other environment, but in the coronavirus era of airline desolation it is par for the course. Unquestionably value will return to some of these investments over the intermediate to long-term, yet some of these investments are under intense financial stress: Virgin Atlantic, for example, is in desperation talks with private equity to keep the beleaguered offspring of Richard Branson intact.
Another investment, Hanjin-JAL (owner of Korean Air Lines), is trading up 100% since the beginning of the year. If seeing an airline in Asia appreciate by 100% in the midst of COVID-19 is bewildering, there is a particular reason for it—and it has nothing to do with fundamentals. A family feud late last year led to a proxy fight for ownership. As equity holders shored up positions to support their particular party, prices spiked. Delta increased their stake in the midst of the price surge, apparently perceiving that an important ally in their Northern Asia network was at risk if leadership was overturned.
Choi Nam-kon, an analyst at Yuanta Securities Korea, wrote in a note: “Once the proxy battle ends, Hanjin KAL’s share price will fall below our estimated target price [of] 33,000 won per share.” For comparison, Hanjin-KAL is currently trading at 77,000 won (a 316% premium to the 52-week low). Factor in additional downside due to the impact of COVID-19 on Hanjin-KAL fundamentals, and my quick and dirty numbers show intermediate values $438M below the carrying value that Delta has on the books.
The effect of how Delta recognizes these investments on an accounting basis is a bit misleading—though it is not inconsistent with pre-coronavirus categorizations (Delta has not changed their accounting method from last year on these investments). For example, utilizing the fair value accounting method for Hanjin-KAL counts the significant price appreciation of Hanjin-KAL on book – to Delta’s advantage. In contrast, with LATAM, Grupo Aeromexico, and Virgin Atlantic Delta utilizes the equity method, which allows fluctuations in underlying value to remain off the balance sheet—and all three of these investments have significantly decreased in market value.
Expect Delta to be forced to take impairment charges soon: LATAM at present is worth $770M less than the carry value Delta has on the books (Delta implied in their March 31st 10Q that they would address this in Q2). The Brazilian government is balking at direct aid for LATAM, creating a hazy forward trajectory—meaning that it will be difficult to continue to characterize LATAM’s downfall as “temporary.” Virgin Atlantic for their part is on the brink of bankruptcy, and will undoubtedly be diluted through debt and potential equity arrangements going forward. Delta is showing a $207M carry value for Branson’s beleaguered airline—likely at least double its intermediate-term value.
Fleet Impairment
The final balance sheet bit to consider is the fact that Delta did not record a substantial amount of the inevitable impairment to their fleet that will occur as the carrier seeks to right-size to the current environment. Delta recently disclosed that they would be taking between $1.4B and $1.7B in impairment charges due to the retirement of their small Boeing 777 fleet, and the remainder of their MD-90 aircraft.
Add $1.5B in fleet impairment to what well may be $1.0B in other airline investment impairments. In most scenarios this would result in serious depreciation of Delta’s position in the market, but the Atlanta based carrier has been so dominant among the long-haul carriers that it simply puts a dent in the size of their advantage. Delta is still the airline to beat among the top tier of national airlines.
At this point cash is king, and here Delta also has a distinct advantage: taking into account contractual obligations through the end of the year, my calculations show Delta with $14B in cash to counter operational losses through the remainder of 2020. By contrast, both United and American Airlines will have a bit under $10B. These numbers assume that all three avail themselves of the full CARES act loan allotment, and ignores the potential for additional loans in the public market. Given Delta’s recent lack of difficulty in issuing $3.5B in bonds, Delta almost certainly remains in better position to add funds through the debt markets than their niche competitors.
Conclusion
For those who are interested in making a bet in the beleaguered airline business, Delta remains one of the most conservative options (and of course the term “conservative” is wildly relative here—there is nothing about the airline business right now that qualifies as conservative in investment terms). The short term horizon for Delta may be a bit choppy with some sizable special items hitting in Q2, but a good portion of these liabilities is already well-known to the market, and so should already be priced in.
If airline demand is as essential as the numbers following 9/11 and the Great Recession implies, the rebound from quarantine reality may well be larger than most are at present projecting. This gives a descent probability of short-term appreciation, though the looming winter months (with an anticipated resurgence of a second coronavirus curve) will produce a distinct upper boundary. The next couple months may well produce good returns to short-term investors, while long-term investors may want to wait until closer to January to start establishing positions.
In the event of sub-$20 share prices, everyone should feel comfortable establishing a small position. The airlines should never be a core position for an investor, but a small sampling at the right time has a good possibility of out producing broad market returns. Delta remains a solid bet in the midst of a disheveled industry.
For more information watch my video discussing in detail Delta’s investments in foreign airlines.
Follow me on Seeking Alpha or Twitter for updated coverage on aviation and the rest of the market. You can watch my video presentation regarding Delta’s balance sheet here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
