More Challenges Await Delta in Second Quarter
We decrease our fair value estimate for the no-moat firm after the airline industry has been grounded due to the COVID-19 pandemic.
No-moat Delta Airlines (DAL) reported a difficult first quarter, as the COVID-19 pandemic has ground air traffic demand to a halt, and management has warned that even worse days are yet to come. After incorporating a more difficult 2020 into our model, we’re decreasing our fair value estimate to $44 per share. Much of the valuation change came from incorporating the capital raise required to bring the company to the desired $10 billion of liquidity at the end of the second quarter into our model, which requires the airline to take on about $2.5 billion of the $4.6 billion loan offered by the government to the firm.
The reasons for near-term negativity are straightforward. Management issued guidance of negative net revenue for the second quarter as refunds outpace bookings. Airlines’ business models are characterized by a substantial fixed cost base in the form of unionized workers, rents, and aircraft ownership costs and thin margins. This means they are likely to face substantial operating losses in 2020 with a near-term demand shock.
Longer term, while it's difficult to say with any certainty when air traffic will return, we are confident that demand will eventually bounce back. We're modeling demand to begin to normalize in 2021. We think the primary risk to airline investors are increased leverage and equity dilution as airlines look to bolster solvency while demand is in the doldrums. We think the best-positioned airlines are firms like Delta, which came into this crisis with relatively little debt and an efficient cost base. Taking this into account, we still think that Delta looks cheap for investors with a strong stomach and a willingness to accept a wide dispersion of outcomes depending on how long travel restrictions last and how willing consumers are to resume traveling.
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Brian Bernard does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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