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Morningstar | Delta Shares Fly High After Third-Quarter Earnings Beat; Slight Raise to Fair Value Estimate. See Updated Analyst Note from 11 Oct 2018

No-moat Delta’s shares traded higher following its third-quarter earnings beat, and we raised our fair value estimate to $63 from $62 on higher yields. We’re encouraged by results from Delta’s premium products, which drove the majority of the carrier’s 8% year-over-year passenger revenue growth and mitigated surging oil prices. Delta shares now trade in 4-star territory after a pre-earnings update from American and Delta drove a sell-off for domestic carriers during the first week of October. At our $63 fair value estimate, we believe an opportunity exists for investors to acquire shares of high-quality Delta.

The domestic and Atlantic passenger businesses continue to deliver sizable revenue gains. Yields were up 3% and 7% for domestic and Atlantic markets, on the back of 5.5% and 3% capacity growth in each respective network. Subsequently, Delta earned 9% and almost 11% top-line growth in its two largest markets (domestic and Atlantic), establishing an 8% passenger revenue growth over the third quarter in 2017. Splitting this out further, Delta earned the meat of its passenger revenue gains from the improvements in business cabin and premium products.

We expect Delta will generate roughly 11% pretax margins after we added management’s raised oil price forecast to our model. Management assumes fourth-quarter fuel price per gallon (including hedges and refinery impact) to finish between $2.47 and $2.52. We now model about $9 billion in fuel expenses (both mainline and regional) for 2018. Together, these assumptions generate full-year earnings per share around $5.45, unadjusted, toward the bottom of management’s guidance of $5.41 to $5.61 when incorporating management’s fourth-quarter earnings projection. We still assume Delta’s fuel expense will retreat through our 2022 midcycle year, thanks to falling oil prices. Fuel expenses don’t fall below $8 billion until 2021, but we expect pretax margins will climb to 14%, gaining roughly 100 basis points a year.

During the September quarter, Delta benefited from robust demand and healthy yield growth, with both revenue passenger miles and passenger yields increasing by 4% over the prior year. Delta logged a 19% improvement over last year in business cabin and premium products. Strong returns from its loyalty program also proved accretive, with third-quarter revenue moving 16% higher over the prior year. Total other revenue, which also includes ancillary and refinery revenue, finished 4% higher over the prior-year period. With management expecting some 8% year-over-year revenue growth in the fourth quarter, we raised our full-year revenue assumptions to over $44 billion.

Even with 4% capacity expansion over the third quarter in 2017, Delta sustained 14% operating margins in the September quarter, showing it can subdue non-fuel costs in the face of growth. We expect to see margin expansion as Delta harvests gains from upgauging, adding more seat miles to its business class and higher revenue cabin products. Enhancing these product offerings carries heightened importance as airlines look to buoy operating margins in a volatile commodity price environment. We’re encouraged by the results we’ve seen so far, and we expect almost 200 basis points of operating margin improvement for 2019.