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Morningstar | Delta Eyeing Takeoff With Decelerating Cost Inflation; Maintaining FVE After Investor Day

We are maintaining our $63 fair value estimate for no-moat Delta Air Lines after its Dec. 13 investor day. The carrier released new guidance for 2019, reinforced long-term projections for EPS, called for ROICs of around 15% going forward, and reiterated its re-fleeting plans through 2023. Amid Brent’s fall from $85 at the start of the fourth quarter, to $60 today, Delta looks poised to re-ignite margin expansion heading into 2019. Management pulled down Brent oil price assumptions but maintained its 2019 capacity growth near 3%. Moreover, the carrier guided for oil prices between $65 and $70 for 2019, allowing the carrier to guide to fuel cost savings of roughly $300 million. While we also envision low fuel prices in 2019, we're a bit more aggressive than management and forecast Delta erasing close to $400 million in fuel costs. Our fuel cost assumptions rest on Brent oil prices gradually receding to our $60 midcycle price through our 2022 normalized year.

For the coming year, Delta expects to achieve pretax margin expansion of more than 100 basis points and adjusted EPS between $6 and $7, which lines up with the 200-basis-point margin expansion and adjusted EPS of $6.40 in our valuation model. We were encouraged by the carrier’s ability to stymie non-fuel costs per available seat mile, or CASM. Management set out to limit non-fuel CASM to less than 2% in 2018, which it accomplished. And now it expects to replicate its success, keeping non-fuel CASM growth to a range of flat to up 2%. Our model incorporates non-fuel CASM growth around 2% over 2018. Combined with growing loyalty program contributions and increased exposure to high revenue cabin configurations, we project that Delta's 2022 pretax margins land 200 basis points above the 12% pretax margins we forecast for 2019. Our midcycle adjusted 14% pretax margins translate to a 15% operating margin, short of management’s long-term guidance calling for margins of around 17%.

We were encouraged by Delta’s capacity outlook for next year and we believe its 3% capacity growth allows room to steadily increase margins in an environment that will soon challenge yield growth. Our model incorporates capacity growth near 3% in 2019 and 2020, but closer to 2% in the back half of our five-year stage I period. We believe the global air travel market will likely exit its record upcycle in the coming years. Through the end of our forecast period, we assume Delta will drive capacity growth from re-fleeting, or swapping out smaller planes for larger planes, and growing international traffic in its ever-expanding global network. Delta plans to replace 35% of its mainline fleet by 2023, slashing the fuel burn per seat by at least 20% and increasing the presence of its premium offerings by 12% in regional jets, 50% for narrowbody aircraft, and 50% for widebodies. We also expect Delta’s intense focus on foreign markets will grow as a priority as it seeks to improve joint venture coordination and initiate new partnerships with carriers in untapped markets, like Westjet.

Delta’s judicious approach to capacity expansion will help it offset what we see as coming margin pressure from a confluence of factors like pilot collective bargaining agreements, which become amendable in December of next year, declining fleet utilization rates in a possible downturn, and weak unit revenue under a soft oil price regime. Further, we believe Delta has reinforced its cash flows with by growing exposure to less cyclical American Express rewards. Lastly, we think Delta is the highest quality airline we cover due not only to its robust cash generation and solid margins but also its investment-grade balance sheet, which is uncommon among airlines.