There are many ways to make money in this world.
But many of these ways are overly complicated and risky.
There’s no reason to take a simple concept and make it unnecessarily complex.
Heed this advice from billionaire investor Warren Buffett:
“I don’t look to jump over 7-foot bars. I look around for 1-foot bars that I can step over.”
Indeed, the way I’ve approached this advice is by practicing dividend growth investing.
And these companies make a lot of money doing so. Not only that, they tend to make more money, year after year.
It’s nonsensical to exert oneself jumping over high bars when these low bars are staring at you in the face.
See what I mean by checking out the Dividend Champions, Contenders, and Challengers list.
It contains invaluable data on more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
These companies are all around you.
Investing in a high-quality company paying a reliable and rising dividend is, in my opinion, the equivalent of stepping over a one-foot bar.
Stepping over one-foot bars can be incredibly rewarding.
I’ve stepped over a lot of one-foot bars in my life.
And I was able to go from below broke at 27 years old to financially free at 33 by doing so, as I lay out in my Early Retirement Blueprint.
I now control the FIRE Fund.
That’s my real-money early retirement dividend growth stock portfolio.
It generates the five-figure passive dividend income I live off of.
But one can’t go around blindly stepping over bars.
An intelligent investor always analyzes an investment for fundamentals, competitive advantages, risks, and valuation.
That last element can be particularly critical.
Price only tells you what you pay. Value is what you get.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
All else equal, because price and yield are inversely correlated, a lower price results in a higher yield.
This higher yield leads to greater long-term total return potential.
Total return is, after all, the sum of investment income and capital gain.
Boosting yield gives you more potential investment income.
Capital gain gets a potential boost, too, via the “upside” between a lower price and higher intrinsic value.
These favorable dynamics also reduce risk.
Undervaluation introduces a margin of safety.
That’s a “buffer” that protects the investors downside against unforeseen issues.
An undervalued high-quality dividend growth stock can be a terrific long-term investment.
The good news is, it’s not difficult to find these one-foot bars.
Fellow contributor Dave Van Knapp has made that easier than ever.
His Lesson 11: Valuation, which is part of an overarching series on dividend growth investing, explicitly lays out what you need to know in order to value dividend growth stocks.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Delta Air Lines, Inc. (DAL)
Delta Air Lines, Inc. (DAL)Delta Air Lines, Inc. (DAL) is a global airline company based in the United States.
Headquartered in Atlanta, Delta Air Lines serves nearly 200 million people every year.
The company serves more than 300 destinations worldwide in over 50 countries across its industry-leading global network.
The company’s passenger revenue for FY 2018 breaks down geographically as follows: Domestic, 71%; Atlantic, 16%; Latin America, 7%; and Pacific, 6%.
Measured by revenue passenger miles, Delta Air Lines has an estimated 17% domestic market share.
If we want to talk about one-foot bars, it doesn’t get much more obvious than this one.
There’s a very clear global megatrend occurring right now.
It’s international tourism.
Globalization has made international tourism a far more affordable and accessible leisure activity.
People all over the globe are taking advantage of this.
Not that long ago, it was a very expensive luxury to be able to visit some faraway country.
However, international tourism is now a juggernaut of an industry that offers far-reaching opportunities and consequences.
If we scale it down into just the United States, the domestic airline industry is a ~$175 billion market. That’s just one country.
According to the World Tourism Organization, there were 1.4 billion international tourist arrivals in 2018. That’s up ~6% compared to 2017.
I’m seeing this global megatrend play out right in front of me.
I currently live in Thailand. A very popular country for tourism. I see tourists stream in every single day. People come from the US, Australia, Europe, and China to indulge in Thailand’s offerings.
Well, these people aren’t arriving by teleportation.
They’re arriving here on jets.
And this same story is playing out all over the world.
That’s the one-foot bar I’m talking about.
Warren Buffett has already stepped over this one-foot bar. Delta Air Lines stock is a prominent holding in the $200+ billion common stock portfolio he oversees for Berkshire Hathway Inc. (BRK.B).
I also hold this stock.
You may want to consider holding it, too.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Even though stepping over these low bars is easy, you’re still paid for your efforts.
Actually, you’re often paid ever-more money for an easy action you may have only committed once in your life.
Delta Air Lines is certainly paying their shareholders more money – a lot more money – year in and year out.
They’ve increased their cash dividend for seven consecutive years.
The five-year dividend growth rate is a colossal 61.3%.
However, much of that dividend growth was fueled by the raising of a very low payout ratio.
The most recent dividend increase of 15% is more representative of what investors might expect from the airline.
That would still be more than enough dividend growth to wet anyone’s appetite, especially when considering the fact that the stock yields 2.82%.
This yield, by the way, is more than 130 basis points higher than the stock’s five-year average yield.
Now, I think much of this is due to the fact that the dividend has been growing so aggressively. The yield hasn’t had a chance to normalize quite yet.
But there’s still clearly a disconnect between the current yield and the yield that’s typically been expected and accepted over the last five years.
Plus, let’s not forget that this yield is much higher than the broader market’s yield.
You’re getting plenty of yield and growth with this stock. Maybe that’s why Buffett likes it so much.
And with a payout ratio of only 22.7%, the air line has plenty of room for many more sizable dividend increases.
It’s a cyclical business model. The company has to carefully manage the payout ratio. But there’s a lot of flexibility here.
The dividend metrics offer dividend growth investors plenty to like.
Revenue and Earnings Growth
Of course, the most important consideration is where the dividend is going, not where it’s been.
This will depend quite a bit on where the entire company is going.
In order to estimate that future path, I’ll build out a growth trajectory.
I’ll first show you what Delta Air Lines has done over the last nine years in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast like this should give us plenty of data to draw some reasonable conclusions.
Delta Air Lines grew its revenue from $31.755 billion in FY 2010 to $44.438 billion in FY 2018.
That’s a compound annual growth rate of 4.29%.
That’s a very respectable number, in my opinion. I usually look for mid-single-digit top-line growth from a mature business, and Delta Air Lines is basically right there.
Now, I like to use 10 years as a proxy for the long term. But I’m factoring out FY 2009 in this look back at the company’s long-term growth because 2009 represented the nadir of the Great Recession, pushing Delta Air Lines into a loss.
There’s also the fact that Delta Air Lines completed a transformational merger with Northwest Airlines in 2008. I think using FY 2010 as a starting point is more accurate in terms of the combined company’s profit ability.
Keep in mind, this is a cyclical business model. A future recession would put pressure on profit.
However, the airline industry has massively consolidated in recent years. There are now only four major domestic airlines.
Furthermore, the Great Recession wasn’t a garden variety recession; it was one of the biggest financial disasters the US has ever seen, which is unlikely to be repeated any time soon.
Earnings per share over this nine-year period increased from $0.70 to $5.67, which is a CAGR of 29.89%.
That’s obviously stellar.
Industry consolidation, rational pricing, considerable share buybacks, and margin expansion have all conspired to put Delta Air Lines on the map as a high-quality company capable of sustainable and significant long-term profit growth.
But I do think it’s important to note that FY 2010 was a very low starting point in terms of EPS. It was near the bottom of the financial crisis. And so an acceleration off of that low point was almost inevitable.
Still, even more recent profit growth is very, very impressive.
For instance, GAAP EPS for Q3 FY 2019 grew more than 20% YOY.
With Delta Air Lines continuing to aggressively buy back stock, the company’s EPS essentially has a built-in floor.
For context, the outstanding share count is down by 18% over the aforementioned nine-year period.
Looking forward, CFRA is anticipating that Delta Air Lines will compound its EPS at an annual rate of 12% over the next three years.
The company has a 73% market share at Hartsfield–Jackson Atlanta International Airport – the highest of any carrier at a hub. What’s especially noteworthy here is the fact that this airport is the busiest (by passenger traffic) in the world.
Delta Air Lines dominates the busiest airport hub on the planet.
That’s highly valuable scale and placement.
In addition, the company’s loyalty program, Delta SkyMiles, helps retain customers in an industry that features effectively no switching costs.
This relates to a long-term relationship the carrier has with American Express Company (AXP).
Delta Air Lines sells miles to American Express, which is mutually beneficial.
This creates stickier customers on both sides. And it’s a great direct revenue source for the airline.
A more near-term tailwind is the fact that there are no Boeing Co. (BA) 737 Max aircraft in the fleet of Delta Air Lines.
That means they’re totally insulated from the ongoing issues with that particular model. This simultaneously gives them an advantage over competitors that are dealing with groundings.
On the flip side, a future return to service for the Max would mean additional industry capacity.
I think CFRA’s 12% target is more than doable. If anything, it’s conservative.
The major question mark here is where we’re at in the economic cycle, especially in the States. Delta Air Lines is still largely a domestic airline.
A recession would definitely cause some turbulence (excuse the pun) in earnings. But if the economy has a soft landing (excuse another pun), and a major recession does not occur in the near future, Delta Air Lines is set for very smooth sailing (I couldn’t resist).
If we take a 12% three-year CAGR in EPS as our base case looking forward, that sets shareholders up for big dividend raises.
After all, an extremely low payout ratio gives the company plenty of flexibility here in terms of rewarding shareholders with growing cash dividends.
I don’t think it’s unsensible to expect low-double-digit dividend raises for the foreseeable future, with the understanding that this will flatten out and normalize at some point in the next 5-10 years.
Financial Position
Moving over to the balance sheet, the company has positioned itself very well.
An airline is a capital-intensive and asset-heavy business model. However, there’s evidently a thoughtful and responsible approach to leverage here. I think this speaks volumes about management’s prudence.
The long-term debt/equity ratio is 0.60, while the interest coverage ratio is sitting at almost 19.
These numbers are very strong for the industry.
Profitability, as indicated earlier, has materially improved over the last decade.
Over the last five years, the company has averaged annual net margin of 8.26% and annual return on equity of 29.22%.
For perspective, the airline was regularly posting up low-single-digit net margin 5-10 years ago.
It’s clear that this has become a much higher-quality company across the board.
I believe the initiation and regular growth of the dividend is a result (and evidence) of that rise in fundamental quality.
In terms of profitability and the balance sheet, only Southwest Airlines Co. (LUV) is competitive with Delta Air Lines. The other two major domestic carriers aren’t even close.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
While competition has been greatly reduced in recent years, it remains fierce.
In addition, the age-old issues with the airline industry in general continue to plague these stocks from a long-term investment standpoint.
Namely, the exposure to volatile fuel prices, high fixed costs, and acute sensitivity to economic cycles are problems that keep a lid on valuations.
More specific and recent issues regarding the trade war between US and China, the late stage of the economic cycle, and Brexit are also undoubtedly risks for global airlines.
Stock Price Valuation
However, an extremely attractive valuation could make this stock a more compelling long-term investment than it’s perhaps ever been.
Well, an extremely attractive valuation looks to be upon us…
The stock’s P/E ratio is sitting at a lowly 8.0.
Even for an airline, that seems ridiculously low.
the_ad id=”83955″]Compare that to the broader market’s P/E ratio that’s more than twice as high. Better yet, compare that to the stock’s own five-year average P/E ratio of 12.2.
The current multiple on cash flow also looks very low.
At 4.3, it’s way off of the stock’s three-year average P/CF ratio of 5.9.
And the yield, as noted earlier, is substantially higher than its own recent historical average.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.
That DGR is on the higher end of what I ordinarily allow for.
But I think the low payout ratio, clear commitment to dividend increases, big buybacks, near-term EPS growth projection, long-term growth track record, and overall quality and health of the business warrant it.
[I could argue that Delta Air Lines actually has the ability to grow its dividend at a higher rate than this, especially over the next few years.
However, the cyclicality of the business model and uncertainty regarding the global economy would cause me to err on the side of caution.
The DDM analysis gives me a fair value of $69.23.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
This looks to me like a high-quality dividend growth stock trading hands for an attractive valuation.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates DAL as a 3-star stock, with a fair value estimate of $59.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates DAL as a 5-star “STRONG BUY”, with a 12-month target price of $75.00.
A bit of a range. I came out somewhere in the middle. Averaging out the three numbers gives us a final valuation of $67.74, which would indicate the stock is possibly 19% undervalued.
Bottom line: Delta Air Lines, Inc. (DAL) is a high-quality company perfectly positioned to capture huge growth from a global megatrend. It looks like one of Warren Buffett’s “one-foot bars”. With a market-beating yield, huge dividend growth, an extremely low payout ratio, and the potential that shares are 19% undervalued, dividend growth investors should carefully consider buying this stock and flying high.
-Jason Fieber
Note from DTA: How safe is DAL’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 61. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, DAL’s dividend appears Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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