On Friday, United Airlines (NASDAQ:UAL) walked away from a bond deal. Unfortunately, that’s likely to bring some bad juju to peer Delta Air Lines (NYSE:DAL). DAL stock will take a hit since it seems pretty clear now that airlines can no longer borrow money.
After the market closed on May 8, United Airlines canceled its $2.25 billion bond offering. Bloomberg reported that the terms became too onerous for the company. The interest rate was going to be 11%. That was too much.
Everyone knows that kind of interest rate is unsustainable in the long term for a large company. What is going on here?
For one, United warned of “essentially zero demand” for air travel in early April. Delta and other airlines are in the same boat. The situation has improved somewhat since then, but demand is only just taking off. Most states are just beginning to lift restrictions on non-essential movement.
What Should You Do When You Can’t Borrow?
Essentially, major airlines like Delta, United and American Airlines (NASDAQ:AAL), have lost their ability to finance ongoing losses with debt. From here on, without cash flow, they are going to have to raise equity or convertible debt with elements of equity. They don’t have other options if they need cash.
They could also sell assets, like their planes, or landing slots or other types of income. This may be hard to do. For example, most airlines lease their planes, with no basic equity. I suspect management may become very creative about this. They will also need these assets, in the long run, to return to robust profitability.
DAL stock seems to be in slightly better shape than the average airline. The problem is the company is still burning $100 million per day. I recently estimated that the company will spend $6.75 billion in the second quarter and will likely run out of money sometime in Q3.
What Is Next for DAL Stock?
This problem could change if air travel by regular Americans picks up dramatically. But, don’t count on that happening. Most airlines are now going to restrict their available revenue by keeping an empty chair space between passengers.
Secondly, Americans are still scared. Everyone has seen the illustrations of how a single cough spreads in a confined space.
So, here is the bottom line: Delta Air Lines is going to need more money. It will likely have to issue common stock to raise this cash.
When the market begins to realize this, DAL stock will begin to fall again. In my last article on Delta, I suggested that most investors would wait until the stock falls well below its book value per share. That price is $22.43 per share.
In fact, you should follow the “margin of safety” principle that Ben Graham wrote about in his book The Intelligent Investor, and which Warren Buffett promotes. This means wait until DAL stock is selling for two-thirds or less of its book value per share.
That would put the stock at $14.93 per share or so. In other words, don’t be in such a rush to capture some huge upside. Delta is deeply indebted and still losing money.
What’s the Fallout From Buffett’s Decision to Sell?
Warren Buffett’s decision to completely exit his company’s holdings in airline stocks hurt the industry last week.
I suspect his decision will prove right in the long run. However, he has other reasons to sell. He runs an insurance company. That kind of company cannot tolerate investment losses. The modus operandi is to sell losers and hang on to winners.
Moreover, Buffett pointed out that the airlines would have a hard time paying off the loans, even if people did return to travel. This would leave little room for shareholder profits. He did not do a detailed forecast. This was his gut feeling for the future of this industry.
Watch Out for Dilution With DAL Stock
Buffett’s gut forecast is likely to play out for Delta. I would wait until the stock trades well below its book value before buying if I was considering an investment.
Just be careful about one thing. If Delta has to issue more equity, that will dilute existing shareholders and the stock may begin to sell below its book value.
Be careful to recalculate a revised book value per share, taking into account the larger number of shares outstanding. This lowers the book value per share and lowers the level of a margin of safety.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here.
