Could this Stock Double Your Money?
When investors think about “swinging for the fences,” they usually need to seek out risky small companies that are undiscovered and poised to take Wall Street by surprise. Yet there’s another way to find a “home-run stock” — by looking for large, well-established companies that have moved deeply out of favor and figure out what it will take that stock to move back into favor. This approach requires ample patience, perhaps a year or two, but the upside can be significant if your analysis is correct.
Right now, there’s a company that dominates its industry, has tremendous power when industry trends are favorable and is still in the midst of a far-reaching transformation that will unlock more profits when it’s complete. I’m talking about Airlines (NYSE: DAL). Shares touched an 18-month low on Wednesday. The carrier is being hit will all kinds of challenges, but these challenges are surmountable. And when they pass, shares could double from here. Doing so would simply bring the stock back to its 52-week high hit last November.
The best horse in the race
Just last week, I took a deep look at rival AMR (NYSE: AMR), parent of American Airlines, and found the company to be in such trouble that bankruptcy is a real possibility in coming years. In so many respects, Delta is strong where AMR is weak. This means Delta should survive in a lousy economy and thrive in a rising economy.
As an example, AMR has been hemorrhaging cash the past few years and is taking the risky move of loading up its debt-laden balance sheet even more in order to lease a lot of new planes. In contrast, Delta is focused on generating as much free cash flow as possible. The carrier generated $1.4 billion in free cash flow last year and should generate at least a similar amount this year. “We were not pleased when Delta ramped up capacity the moment corporate travel recovered in 2009/10, but with capacity now being cut aggressively we find the investment case for DAL compelling,” note analysts at UBS.
Delta announced plans in April to throttle back capital spending to help remove another $3 billion in debt from its balance sheet by the end of next year, after having reduced a similar amount during the past 18 months. “With few aircraft on order, Delta is expected to generate more than $2 billion in annual free cash flow through 2012,” predict analysts at Merrill Lynch.
To be sure, Delta still carries more than $14 billion in debt, against just $785 million in shareholder’s equity. Yet that’s precisely the kind of set up that allows investors to score big returns as leverage works in the company’s favor. Strong free cash flow can yield very impressive returns on equity, which exceeded 250% last year. (You read that correctly.)
A tough slog
Make no mistake, the airline industry has hit a rough patch as stubbornly high fuel costs and slowing demand hurt quarterly results. Delta just missed quarterly per share profit estimates by $0.06 and announced plans to lay off 2,000 employees. Still, Delta generated an eye-popping $700 million in free cash flow in the second quarter. Look for more of the same in the current quarter before a seasonal dip in the fourth quarter and again in the first quarter of 2012.
Looked at another way, shares trade for about four times projected 2012 free cash flow, which means they sport a 25% free cash flow yield. Why so low a multiple and so high a yield? Because investors are treating airline stocks as if it is 2008 when the prospects of bankruptcy loomed quite large. Yet is that a real concern? Delta just ended the quarter with $5.6 billion in unrestricted liquidity ($3.8 billion of which is in cash and the rest in an untapped credit line). It would have to take an economic slowdown of catastrophic proportions to force Delta into bankruptcy. Weaker rivals such as AMR would be forced out of business long before then.
To be sure, Delta faces serious challenges from high fuel prices. Operating expenses jumped $1.4 billion in the second quarter compared with a year ago, with most of that coming from rising jet fuel prices. In response, the company plans to reduce capacity by around 4% to 5% in the December quarter, cutting flights that consume the most fuel relative to ticket prices. The carrier also just announced plans to retire 140 of its most inefficient planes by the end of 2012. “We’re very focused on being certain that the flying we do produces positive cash flow — it’s that simple,” noted CEO Richard Anderson on a with analysts.
Even as the carrier hunkers down to conserve costs, Delta still has several levers to pull to boost revenue. For example, a recent of gates with U.S. Airways (NYSE: LCC) will sharply boost Delta’s presence at New York’s LaGuardia airport, a highly lucrative part of Delta’s network. And management continues to do an industry-leading job of fine-tuning pricing. The carrier boosted passenger revenue per average seat mile (PRASM), a key industry metric, by 180 basis points in the second quarter, and July is off to a good start as well. “Delta sees July PRASM increasing 8%-9% as compared to our estimate of industry PRASM growth of 5%-6%, and management expressed optimism for the remainder of the quarter based on booking trends,” note Merrill’s analysts.
Action to Take –> Delta is adjusting to more sobering times, tightening its belt where necessary to maximize cash flow and profits. Even with the major fuel price headwinds in place, Delta is on track to earn more than $1 share this year. Looking ahead to 2012, a pair of scenarios could play out…
First, the crisis in Libya could get resolved, and the country resumes its past level of oil output, shaving crude oil prices by 10% to 20%. This would quickly push Delta’s potential earnings per share (EPS) toward the $2 mark (analysts are currently modeling for $1.83). Shares could easily fetch eight times that mark, or $16 a share.
But let’s assume oil prices remain high and the global economy remains weak in 2012. Delta’s per share profits would likely be closer to $1 a share, and the above-noted scenario is pushed out to 2013. To realize a double in this stock, you may need to wait that long. But make no mistake, this is a seriously undervalued stock, trading at just four times projected free cash flow (which is much more robust than net income, thanks to high levels of depreciation). When fears of a global meltdown recede, investors would happily pay up to acquire Delta’s shares with a 10% free cash flow yield. This math would shares rise 150% from current levels.
These are all round fuzzy figures, and it’s hard to be precise with unknowns such as fuel prices and economic growth. Yet it’s clear Delta is an extremely well-run company with a very cheap stock. Patient investors should be amply rewarded for rising out these tough times.
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