Delta's Dividend Safety Score Downgraded to Borderline Safe as Virus Concerns Pressure Airlines

The International Air Transport Association (IATA) now expects the coronavirus to cause the global air transport's 2020 revenue to fall between $63 billion and $113 billion, or as much as 20%.

This is expected to pressure the cash flow of most airlines, which are very sensitive to changes in demand due to their high fixed costs.

While Delta Airlines (DAL) remains one of the strongest operators, we are downgrading the company's Dividend Safety Score from Safe to Borderline Safe in order to be conservative and better recognize today's increasingly difficult environment.

Many airlines have announced capacity reductions and emergency cost reduction measures to conserve cash during this challenging time. Delta is no exception.

On March 10, the company responded to the decline in traffic demand by announcing international capacity reductions of 20-25% and domestic capacity reductions of 10-15%.

Management also announced a number of cost reduction initiatives and cash flow decisions, including deferring $500 million in capital expenditures, delaying $500 million of voluntary pension funding, and suspending share repurchases.

For context, in 2019 Delta generated $8.4 billion in operating cash flow and tallied $4.9 billion of capital expenditures, resulting in free cash flow of $3.5 billion.

This was more than enough to cover the company's dividend obligation, which will sit just above $1 billion this year.

However, during the financial crisis when Delta's passenger revenue fell 20%, the company's operating cash flow swung from $1.4 billion in 2007 to a loss of $300 million in 2008-09.

Aside from falling fuel prices, which Delta believes will reduce its expenses by $2 billion, this year's environment could present similar challenges based on the IATA's latest revenue forecast for the industry.

Even after baking in lower fuel prices and a reduction in capital spending, we estimate that Delta's dividend would no longer be covered with free cash flow if the firm's operating cash flow fell 40% to 50% this year.

This scenario seems within the realm of possibilities this year given the industry's expected revenue loss and would require Delta's dividend to be (temporarily) funded by its balance sheet.

However, Delta likely wants to maintain its BBB- credit rating which is only one rung above junk status, escalating its need to preserve cash.

Fortunately, the company strengthened its balance sheet over the last decade, and leverage sits at the low-end of its targeted range. Delta also notes its liquidity exceeds $5 billion and the firm has $20 billion of unencumbered assets (most owned aircraft) it could borrow against.

In other words, at least for an airline, Delta was financially positioned about as well as it could have been going into the coronavirus fallout, providing some flexibility.

For example, if Delta failed to generate operating cash flow this year and spent $5 billion on capital investments and dividends, we estimate its net debt to EBITDA ratio would rise from 1.7x to 2.8x (using 2019 EBITDA to represent a "normal" level of cash flow).

That's not a dangerously high level, but management probably would not want leverage to move up any further. Depending on the travel industry's outlook at that time, the pressure on Delta's dividend could become much higher.

Our Borderline Safe score reflects that possibility which is compounded by the fact that operating airlines is a tough business.

For example, Delta declared bankruptcy in 2005, when it was the third largest airline company. Southwest (LUV) and JetBlue (JBLU) are the only two major airlines that have not filed for bankruptcy.

Volatile fuel prices, costly union labor forces, steep price competition, and capital intensive operations are just some of the major challenges faced by airlines. There are some positives, however.

The high costs required to operate an airline create barriers to entry. A large operator such as Delta can spread its fixed costs across all of its routes, allowing it to deliver it services more efficiently than smaller rivals or new entrants. 

Only so many routes between two destinations are needed as well, making it all the more difficult for a new player to gain share.

The big operators have consolidated in recent years, too. Delta Air and Northwest Airlines merged in 2008, United and Continental combined forces in 2010, and American Airlines and US Airways Group merged in 2013.

According to the Wall Street Journal, American, United Continental, Delta Air Lines, and Southwest now control more than 80% of U.S. domestic capacity, up significantly compared to the years before the jump in merger consolidation activity.

It remains to be seen if this consolidation can result in a more rational competitive environment, marked by higher ticket prices and improved profitability from economies of scale and restructuring initiatives. Especially during a period of weak demand like we are experiencing now with the coronavirus.

Warren Buffett has taken a surprising liking to airline stocks in recent years, likely betting that the industry's consolidation will drive sustained improvement in long-term profitability. Berkshire Hathaway owns about 11% of Delta's shares, making it the firm's biggest airline holding.

Berkshire was likely attracted to Delta’s competitive advantages, which are outlined here. Delta’s union labor force is much smaller than its rivals, the company is the largest airline by passenger volume (helps airplane utilization and leverages fixed costs), Delta buys cheaper used aircraft, and it even owns its own fuel refinery to save on costs.

These qualities help Delta generate more consistent free cash flow and earn higher returns on its invested capital compared to many of its rivals.

Overall, we expect Delta's long-term outlook to remain intact. However, investors considering the stock need to be comfortable with the airline industry's spotty history and Delta's poor near-term visibility as the coronavirus continues to spread. The dividend appears stable for now, but that could change if air traffic remains weaker for longer than a few quarters.