Delta Air Lines is one of the largest airlines in the United States. Should you buy the airline stock following its impressive Q2 results?
The airline industry was among the worst hit amid the COVID-19 pandemic. As borders were shut and countries imposed lockdowns, revenues for airline companies nosedived by a significant margin.
Prior to the pandemic, airlines reported 10 consecutive years of profits as interest rates remained low and travel demand was extremely robust. But during the height of the pandemic, airline companies including Delta Air Lines (NYSE: DAL) slashed travel routes, reduced their workforce, and even requested employees to consider unpaid leave arrangements.
In an investor letter back in 2007, Warren Buffett emphasized it makes little sense to park funds in capital-intensive sectors such as airlines as companies generate negligible profits. Most airline companies find it difficult to enjoy a "durable competitive advantage" over the long term.
According to Buffett, while revenues may continue to rise it does not translate into sustainable profits due to rising competition, expansion of traffic routes, and significant investments undertaken to expand passenger capacity.
But in 2016, Buffett's Berkshire Hathaway (NYSE: BRK.B) owned stakes in four major airlines in the U.S. The move surprised Wall Street and Buffett claimed the landscape of airline companies had changed for good as the top four players owned 80% of the total market.
In May 2020, Buffett confirmed Berkshire liquidated positions in all airline stocks and also vowed never to enter the sector again.
While the Oracle of Omaha has shied away from investing in the airline sector, lets see if Delta Air Lines can stage a comeback in the back end of 2022.
In the second quarter of 2022, Delta reported revenue of $13.82 billion and adjusted earnings of $1.44 per share. Analysts forecast the company's earnings at $1.64 per share in Q2 on revenue of $13.4 billion. The lower than expected earnings was attributed to an elevated cost environment which is unlikely to ease in the near-term.
Strong vacation demand in the U.S. allowed Delta to deliver solid revenue numbers in Q2. But most airline companies have to wrestle with higher labor and fuel costs, in addition to a shortage of pilots. These factors led to the company reporting an adjusted operating margin of 11.7% -- below its guidance of between 13% and 14%.
However, despite cost-related headwinds, Delta ended Q2 with free cash flow of $1.6 billion. In the first six months of 2022, total free cash flow stood at almost $2 billion.
The company emphasized its total unit revenue was 20% higher in Q2 compared to the same period in 2019. This metric is calculated by dividing total revenue by the available seat miles.
Pent-up travel demand should ensure unit revenue will remain encouraging in Q3 as well.
Delta expects sales in the third quarter to increase between 1% and 3% compared to the same quarter in 2019. But its operating capacity is expected to fall around 16%, indicating unit revenue gain of 23%. It's quite evident that the airline heavyweight enjoys pricing power, allowing it to offset higher expenses.
What next for Delta Air Lines stock and investors?
Delta Air Lines is forecast to report revenue of $49.63 billion and adjusted earnings of $2.78 per share in 2022. So, it's valued at 0.40x forward sales and 11.3x forward earnings. A key reason for its extremely cheap valuation is the company's debt balance of $33.7 billion. Investors are worried about rising interest expenses eating into profits amid an inflationary environment.
However, Delta is optimistic about widening its adjusted earnings to $7 per share by 2024 and generating $4 billion in free cash flows, which might allow the stock to deliver outsized gains to investors.
But airlines is an extremely cyclical sector, suggesting Delta Air Lines and its peers might underperform if a recession hits the global economy in 2022. Given the uncertainties surrounding this sector, Delta seems like a high-risk high-reward bet right now.
