RealMoney Silver - Delta Looks Like a Dangerous Short

Delta Looks Like a Dangerous Short
By Bill Trent
RealMoney.com Contributor
9/17/2007 11:28 AM EDT

When I saw out-of-the-money Delta Airlines (DAL) calls on Stockpickr's stocks with heavy option volume, my first thought was that it must have been one of the short-squeeze airline plays also mentioned on Stockpickr. Nope. So that got me thinking. I typically don't want to touch airlines with a 10-foot pole, but they do make for the occasional good trade. Is this one of those occasions?

For me, even a speculative trade has to have something underneath it for support. At first glance, it looks like Delta has that. 2008 EPS estimates are at $1.80 and have been marching up steadily, now giving the company a single-digit P/E multiple.

Price/book is also low, but only because it exited bankruptcy with a load of goodwill on the balance sheet. Excluding that, the book value is negative. Delta has a fair amount of cash, but plenty of near-term liabilities on which to spend it.

All in, its total net debt is more than $5 billion, resulting in an enterprise value of $9.7 billion. If Delta keeps generating the cash flow it did during the first half of 2007, the double-digit free cash flow yield could be enticing.

The problem with those valuations, though, is that they rely on the accounting numbers on the face of the financial statements. The last 10Q disclosed that after the June 30 financial statement dates, but before July 31, the company issued another $66 million in debt and paid $303 million cash to terminate pension plans and settle some other obligations.

Then, on Aug. 28, it was required to issue $650 million in debt to its pilots in exchange for salary concessions it had made.

The company has settled $11.4 billion of bankruptcy claims by issuing common stock, but "currently estimate that the total allowed general, unsecured claims in our Chapter 11 proceedings will be approximately $15 billion, including claims with respect to which we have issued or commenced distributions of common stock." That means that another $3.6 billion is not yet on the books, even assuming its estimate is correct. That brings the enterprise value to $14.3 billion, and the free cash flow yield below 7%. Who knows how many shares will have to be issued to settle the claims, so I won't even talk about the P/E.

What's more, airlines are notorious for off-balance sheet and other obligations. Delta has 136 aircraft under operating leases, which make up about a quarter of its fleet but do not appear on the balance sheet. If these were treated as company-owned aircraft, the assets and liabilities would each increase by about $3.5 billion (assuming the leased aircraft are worth about as much, on average, as those that are owned.) Now we're down to a 5.4% yield on an adjusted enterprise valuation of $18.8 billion.

How quickly we get from something that looks enticing to something that looks like it came out of bankruptcy five months ago. Which, of course, it did.

DAL would probably be a dangerous short due to the leverage and the apparent cheapness. I'd sell a position I owned and consider put options if they were cheap enough.

Bottom line, if you want to take a flier on an airline, I'd stick with one of the short squeeze plays. The majors still look like they can cause a major league stomachache.