Delta’s empire building: strategic, economic and tax benefits? Jan/Feb 2016
Delta is quite unique in the US industry for its post-2010 strategy of acquiring minority equity stakes in airlines around the world as part of long-term “exclusive” commercial alliances or immunised joint ventures.
In addition to the continued development of the transatlantic JV with Air France-KLM and Alitalia, Delta has acquired equity stakes in Aeroméxico (August 2011), GOL (December 2011), Virgin Atlantic (June 2013) and China Eastern (July 2015).
Delta’s investment activity on that front has intensified in recent months. In July, in addition to investing $450m for a 3.6% stake in China Eastern, Delta helped out its cash-strapped partner GOL by participating in GOL’s rights offering to the tune of $56m, which increased its ownership stake in the Brazilian carrier to 9%. Delta also guaranteed $300m in GOL loans secured by GOL’s shares in its publicly listed SMILES loyalty programme.
In the summer, Delta also worked with the lessor Intrepid Aviation on a deal that would have given it an equity stake in Japan’s Skymark Airlines, which needed a strategic partner to help it out of bankruptcy. But Delta lost that opportunity in August when Skymark’s creditors voted in favour of an alternative plan backed by ANA.
In November, Delta disclosed that it was seeking to increase its stake in Aeroméxico from 4.1% to up to 49%, subject to regulatory approvals. In March 2015, Delta and Aeroméxico applied for antitrust immunity (ATI) for a new $1.5bn JV in the US-Mexico market, which is expected to be granted when an open skies agreement is implemented.
There have been some cases of minority cross-border investments providing significant economic benefits to the investing airline. Continental’s 1998-2008 investment in Panama’s Copa was such a deal. But the general thinking is that at least small minority ownership stakes tend not to offer many benefits. Many such investments have been either rescue deals or to take advantage of some rare opportunity.
In June, United spent $100m to acquire a 5% stake in Brazil’s Azul. That deal was widely expected, given the huge size and long-term importance of the Brazilian market to US carriers. With American partnered with TAM and Delta with GOL, United-Azul was a virtual certainty And Azul needed cash, because its IPO is now delayed probably until 2017.
No other US airline has considered it worthwhile to pursue minority cross-border equity stakes on a larger scale. So why is Delta doing it?
The benefits of that strategy to Delta actually seem quite comprehensive. They include long-term strategic benefits, clear economic benefits and potentially even tax benefits, which can be summarised as follows:
- Gaining access to major markets
In the first place, the China Eastern, GOL and Aeroméxico investments are aimed at securing long-term access to some of the world’s largest domestic air travel markets — China, Brazil and Mexico.
Delta is talking about establishing hubs at Shanghai and São Paulo, which are its partners’ home bases. Delta CEO Richard Anderson stated recently: “Ultimately, joint ventures will give us the foundation to build the leading US gateways to China and Brazil, including hubs in Shanghai and São Paulo with our great partners China Eastern, China Southern and GOL”.
The Skymark investment would have accomplished a similar goal — gaining access to Japan’s large domestic market, as well as Skymark’s slot holdings at Tokyo Haneda. Delta is severely disadvantaged in the US-Japan market because it does not have a Japanese partner (unlike American and United, which have immunised JVs with JAL and ANA, respectively.
China is vitally important to Delta because it has surpassed Japan as the largest transpacific market from the US and because it is expected to be the fastest-growing international market in the future. Total daily US-China passengers are forecast to double between 2010 and 2020, and the proportion of passengers originating in China on the route is projected to surge from 41% of the total in 2010 to 68% in 2025 (see chart). Delta said recently that China would become the “second key pillar” in its Asia-Pacific franchise but that the China Eastern/Shanghai hub building would be a “decade-long process”.
At Delta’s latest investor day in December 2015, the executives noted that Delta is now “well-represented” in seven of the top ten US international markets, meaning that in those seven markets it either has equity stakes in local carriers (UK, China, Mexico and Brazil), an important JV partner (France and Italy) or a hub (Japan). And the four countries where the equity investments have been made are among the top six US international markets (see chart).
- Network and revenue diversification
Delta views its international alliances, joint ventures and airline equity investments as a key part of efforts to build a geographically balanced network and diversify revenues — strategies that reduce business risk.
Delta generally puts more emphasis on diversification than its peers. For example, it acquired its own oil refinery in Pennsylvania — the Trainer facility, which is now producing profits.
- Capital-efficient international expansion
Another reason Delta is increasingly relying on alliances and joint ventures, as noted by one of its executives: “Equity investments and commercial collaboration with global partners have allowed for capital-efficient international expansion”.
Since its Chapter 11 reorganisation and merger with Northwest, Delta has adopted very conservative spending and balance sheet management policies by most airline standards. Despite having a relatively old fleet, Delta has kept fleet capex to a minimum and sought to maximise free cash flow, which it has used to deleverage the balance sheet and reward shareholders.
Delta has also led the industry in keeping capacity growth restrained. In the spring of 2015, anticipating difficult conditions in international markets, it was the first to move to cut international capacity growth this winter.
In the fourth quarter, Delta’s international ASMs fell by 4.5%, which included a steep 11% capacity reduction on the Pacific and small 1% and 0.5% reductions on the Atlantic and Latin route areas, respectively. The biggest cuts were in challenging markets such as Japan, Brazil and Russia, while key strategic markets such as China and Mexico continued to see growth.
Delta currently expects its system capacity to inch up by only 0-2% in 2016, but international ASMs would be flat-to-down 2%. Growth will focus on markets with strong demand (US domestic, UK, Mexico and the Caribbean), with offsetting reductions in weaker markets (Brazil, Japan, Middle East).
Relying on alliances and joint ventures fits in perfectly with those strategies. For example, in the US-UK joint venture, growth in 2015 (about 10%) was led by Virgin Atlantic, which reallocated aircraft from its lossmaking Asia/Pacific and Africa networks to the transatlantic market.
- Healthy profit contribution
While exact financial figures are not available (treated as confidential information in the case of the joint ventures), the public comments made by Delta’s management indicate that the two transatlantic joint ventures are highly profitable.
Delta has noted in every quarterly call in the past 12 months that the JVs with AF-KLM and Virgin Atlantic have allowed it to continue to expand transatlantic profit margins despite a challenging environment. Many of those markets have seen significant currency pressures, reduced fuel surcharges and excessive industry capacity growth.
The JV with AF-KLM benefits from being the oldest and probably the most deeply integrated of the transatlantic alliances. The JV has 25 aircraft devoted to it and achieves double-digit profit margins.
The Virgin Atlantic deal, which involved Delta buying SIA’s 49% stake for $385m, has fixed Delta’s Heathrow access problem and made it a credible player in the important New York-London business travel market. Thanks to the JV and other initiatives (new JFK terminal, LaGuardia facility improvements and expansion, slot swaps, etc) Delta made its first profit in New York in 2014.
Delta’s management said recently that the $385m investment in Virgin Atlantic in 2013 produced about $150m of cash returns in 2015 and would achieve full cash payback by the end of this year. It is producing a “minimum 50% return on investment”. The executives described it as “probably the single best investment we’ve made in terms of our returns”.
It is worth recalling that three years ago many in the financial community were sceptical of the value of the Virgin Atlantic stake purchase. At that time Virgin was losing money to the tune of $150m annually. Delta’s initial projection had been only $120m annual run-rate benefits when the JV was fully developed.
This year, Delta is bringing Virgin Atlantic to its technology platform, meaning that Delta will operate Virgin’s reservations system. The airlines expect it to result in a seamless customer experience.
The success of the transatlantic JVs has given Delta the confidence to seek similar deals elsewhere. The management has said that the carrier is using those JVs as the model for deepening relationships with partners in other regions.
The Aeroméxico and GOL alliances are already contributing materially to Delta’s revenues — a combined $33m incremental revenue contribution in last year’s Q1 and $25m in Q2. But it is still early days; neither deal yet benefits from an open skies agreement or ATI.
Delta expects this year’s planned $750m additional investment in Aeroméxico to be even more lucrative, with “quick and immediate return”, given Mexico’s relatively robust economic fundamentals and Aeroméxico’s strong market position. But, like the GOL and China Eastern investments, it is a long-term project (more on it in the last section of this article).
- Long-term cost savings
Delta also hopes that the Aeroméxico and GOL investments, in particular, will facilitate cost reductions in the long-term.
In the first place, savings are derived through a joint-venture MRO facility that Delta and Aeroméxico opened in Querétaro, Mexico in March 2014. The airlines disclosed in 2012 that they had invested $50m to build the facility, which Delta said would “usher in lower maintenance costs” without compromising quality.
- Potential tax savings
For many years Delta, like most of its US peers, has been able to avoid paying federal corporate taxes by utilising its net operating losses (NOLs) accumulated during earlier lossmaking years. But thanks to a recent string of record profits, Delta expects to exhaust its NOLs by 2018 and become a full taxpayer that year.
In the US the statutory federal corporate tax rate is relatively high, at 35%, and most airlines pay about 38% — the book rate that Delta has been using. But many European countries have much lower corporate tax rates, typically in the low-to-mid 20s.
At the 2014 investor day, Delta hinted at the possibility that it could obtain tax savings in the future by taking advantage of its international JVs. It could set up a foreign subsidiary for those activities in a country with a lower tax rate.
CEO Richard Anderson remarked at that time that “Amsterdam is a good place”, as Delta has large JVs that are euro-denominated, a 49% stake in a London-based airline and already a large commercial office in Amsterdam for joint venture pricing and yield management. The corporate tax rate in the Netherlands is 25%.
At the latest investor day, Delta commented on what it described as a “transatlantic business reorganisation”. It has involved expanding the Amsterdam office, which now handles all decision-making for Delta’s transatlantic operations. The purpose is to improve the effectiveness of the JVs and accelerate the benefits. “Strong local brands require local decision making capabilities”, the airline said. The executives indicated that similar moves might follow in other parts of the world.
“That structure is going to allow us to make sure that international component is international”, the airline said. As a result, Delta expects its 2016 book tax rate to be 35-36%, down slightly from the 37-38% up to 2015. It is one way to lower book and cash taxes, supplementing the more common methods such as accelerated depreciation and excess pension funding.
Strong financial position
Last but not least, Delta is buying the equity stakes in other carriers because it can easily afford such investments. As an additional plus point, the financial community is not complaining.
Delta was fortunate in that it had a multi-year head-start over United and American on the merger front. It completed a successful merger with Northwest in 2008 and accomplished a quick and smooth integration. So it was able quickly to reap the benefits of the merger and achieve stellar profitability.
In recent years, Delta has beaten its US legacy carrier peers handsomely on all financial fronts, be it profit margins, ROIC, debt reduction or returning capital to shareholders. And Delta is now also claiming that its financial metrics rank among the top 10% of S&P industrials.
In the past six years, Delta has earned $13.4bn in aggregate net profits before special items. That includes a $3.7bn ex-item net profit in 2015. Annual operating margins are now in the high-teens. And Delta earned a ROIC of 28.3% in the 12 months to December 31.
The long term targets outlined by Delta in May 2015 are to deliver annual EPS growth of at least 15%, achieve a ROIC of 20-25% and generate annual operating cash flow of $7-8bn, of which $4-5bn would be free cash flow.
The equity investments in other airlines are a small part of what Delta calls a “balanced capital deployment”. First of all, Delta is reinvesting about 50% of its operating cash flow in the business. That includes investing $2.5-3bn annually into fleet, products, facilities and technology.
Second, Delta continues to strengthen its balance sheet. Having reduced its adjusted net debt by more than $10bn since 2009, from $17bn to less than $7bn, the airline is on track to reach its target of $4bn in net debt by 2020 (see chart). Annual interest costs with $4bn net debt will be around $200m, down $1.1bn from the 2009 level.
On February 11 Delta achieved its long-term goal of becoming investment grade when Moody’s upgraded the company’s debt rating from Ba3 to Baa3. Delta joined a very exclusive club; in North America, only three other airlines — Southwest, WestJet and Alaska — currently have investment grade credit ratings. It must have been particularly gratifying for CEO Richard Anderson, who is retiring in May.
Third, having returned nearly $4bn of cash to shareholders since 2013, Delta has announced a new $5bn share repurchase programme to be completed by the end of 2017.
Last year Delta returned 70% of its free cash flow to shareholders, which was well above its 50% target. With an estimated $3bn fuel tailwind in 2016 (at the $40/bbl price), the airline expects to “vastly exceed” the long-term financial goals this year.
Delta is also committed to funding its pension plans to the tune of $1bn annually. It has a generous employee profit-sharing programme in place. In mid-February Delta made a $1.5bn employee profit-sharing payment for 2015, which it claimed broke all records of corporate profit sharing payouts in the US.
Delta is also taking steps to improve wages. It has granted its ground workers and flight attendants a 14.5% base pay increase, effective from the beginning of December. However, as a setback, Delta’s pilots failed to ratify a new contract in the summer, as a result of which Delta decelerated its already slow fleet renewal; it dropped a tentative order for 40 smaller narrow-bodies (including 737-900ERs) and opted to keep 14 of its aging 757-200s.
However, in December Delta unexpectedly reinstated a big part of that order, saying that it would add up to 20 Boeing-held E190s and 20 new 737-900ERs. This time, the order is not contingent on a pilot deal. “We’re not going to limit our growth opportunities”, the executives said, pointing out that the new deal also had “more compelling economics”.
In short, Delta is generating enormous cash flow and doing a decent job in deploying it in an equitable and balanced fashion. It can be expected to continue acquiring stakes in airlines around the world, given the relatively modest outlays involved, the capital-efficient nature of such expansion, the healthy profits generated by such ventures and the likely tax benefits derived from having assets based outside the US.
The next moves?
Asia could be an area of special focus for Delta. China Eastern was a good start, but Delta could do with more partners in that vast and important region. The management has reportedly talked of the possibility of strengthening the existing partnership with Korean Air.
But the Latin American ventures will also keep Delta busy in the near term, because the impending open skies agreements will make it possible to greatly strengthen the relationships with GOL and Aeroméxico.
However, uncertainties abound. The US-Brazil open skies agreement was supposed to take effect in October 2015, but its ratification by Brazil has been delayed evidently due to the political and economic turmoil in that country. Nevertheless, Delta executives said recently that they expected open skies to come into force in 2016 and that Delta and GOL would file for ATI “shortly thereafter”.
The financial assistance that Delta provided to GOL in the summer (the additional stake purchase and loan guarantee) facilitated an extension of the carriers’ exclusive codeshare agreement. Although the main upside may be in the long term, one would expect an immunised JV to help both carriers in the current tough market conditions on Brazilian routes.
In recent weeks, the three main rating agencies have all raised concern about GOL’s ability to meet its financial obligations in the next 12-18 months, given its continued cash burn due to Brazil’s economic crisis. Moody’s and Fitch have both downgraded GOL’s ratings and S&P has placed it on “creditwatch negative”. Also, the Brazilian government is considering granting President Dilma Rousseff emergency powers to waive the current foreign ownership limits on airlines on a case-by-case basis.
So Delta might be called to help out its partner again. Back in December, Delta executives noted that the next two years would be tough in Brazil, that the GOL investment was for the longer term and that this was a good time to invest in Brazil. They said that they were working with GOL’s leadership in “building a durable model, so that 24 to 36 months from now you’re going to see some significant returns from that investment”.
Delta is going after Aeroméxico really aggressively with its November proposal to increase its ownership stake from the current 17% (including Delta’s 4.1% stake, options and Delta pension trust’s holdings) to up to 49% through a cash tender offer, which it hopes to commence in the June quarter. It would be a $750m cash deal.
It would solidify Delta’s position in what is the largest US-Latin America market and one of the region’s stronger economies. On December 18, the US and Mexico signed a more liberalised ASA, which will become effective once Mexico ratifies it. Delta has also suggested that an open skies agreement could be approved in 2016. The JV would make Delta/Aeroméxico the number one airline system on US-Mexico routes.
But Delta also believes that Aeroméxico will be an even more lucrative investment than Virgin Atlantic because Aeroméxico has a substantial domestic marketplace. Mexico is a “neighbour country with a marketplace that is still relatively underdeveloped”, and Aeroméxico is the “flag carrier with a number one slot position [in slot-constrained Mexico City] much like BA at Heathrow”. Yet, Aeroméxico is only a “6% operating margin business today”.
Delta executives stated at the investor day: “We feel relatively confident, just as we’ve done with Virgin, that with our know-how, our investment and our co-location of resources, that we can double those margins over the next 3-5 years. And that’s going to provide a very nice return on that capital investment”.
Delta may be forgetting something. Mexico has a vibrant LCC sector, with the three leading LCCs accounting for 63% of Mexico’s domestic traffic (and therefore having pricing power) and 41% of international traffic to and from Mexico (July 2015 DGAC data). The high level of LCC competition is one reason why Aeroméxico’s operating margins are lagging. The LCCs have done a lot to develop the domestic market and will fight tooth and nail to retain their market shares. That said, Aeroméxico could still be a successful investment for Delta.