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Most spend more time avoiding the airline sector than they do seeking it out, but the time is ripe for buying this sector stalwart now, writes Elliott Gue of Energy and Income Advisor.

The second-largest US air carrier, Delta Air Lines (DAL) has consistently ranked toward the top of the field in terms of year-over-year growth in revenue per available seat mile (RASM), a testament to the company’s success squeezing additional revenue out of its capacity.

Much of these RASM gains stem from the airline’s market share gains among business travelers, the industry’s highest-margin customers. In 2012, revenue from corporate travelers surged 11.1% from year-ago levels, with broad-based strength across a range of industries.

Delta Air Lines’ increasing popularity among business travelers reflects a number of strategic initiatives. For one, management has sought to enhance its services at key hubs for business travelers, such as New York City’s LaGuardia Airport and London’s Heathrow Airport. Through a series of departure slot swaps with other airlines, Delta Air Lines has increased its share of departures from LaGuardia Airport to 46% in 2012—more than double the share of runner-up American Airlines.

The company is also redesigning its terminal at the airport to make it more convenient for business travelers. These moves have also enabled Delta Air Lines to shift some domestic flights to LaGuardia from New York City’s John F. Kennedy Airport, freeing up slots for additional international departures from Kennedy Airport.

With Delta Air Lines’ business traveler volumes up 11% in New York City last year, these moves appear to have paid off. Management estimates that the airline poached 5% of the corporate market from other airlines that operate in New York City’s airports. Meanwhile, the number of SkyMiles Medallion memberships—the elite of Delta Air Lines’ frequent-flyer program—surged by 10% in 2012.
 
We also like the company’s efforts to gain market share at London’s Heathrow, an airport that attracts three times as many corporate travelers as Charles de Gaulle Airport in Paris. This London hub accounts for 85% of travelers from the top ten US markets. In fact, than 2.7 million passengers travel from New York City to London alone each year, and another 1.4 million travelers fly from Los Angeles to Heathrow.

Delta Air Lines recently agreed to acquire 49% of Virgin Atlantic Airlines from Singapore Airlines (Singapore: C6U) for $360 million. Virgin Atlantic Airlines boasts the second-largest market share (16%) at Heathrow, trailing only the UK’s national carrier, British Airways (BAIRY).

Add in Delta Air Lines’ existing business at Heathrow and the company’s stake increases to almost a quarter of the market. This joint venture will enhance Delta Air Lines’ service to Heathrow and make connections more convenient for business travelers.
 
Delta Air Lines has also rolled out additional amenities on many of its routes that are designed to appeal to corporate travelers. These features includes in-flight Wi-Fi Internet access across most of its routes, upgrades to domestic and international first-class cabins, and the introduction of the economy comfort class, which offers additional legroom at a lower cost than first class.

The airline has also improved its key service metrics dramatically in recent years. In the third quarter of 2012, the percentage of on-time arrivals increased by 9.5 percentage points year-over-year, and customer complaints dropped by 63%. These efforts also lowered the number of mishandled bags by 36% from year-ago levels.
 
We’re also impressed by Delta Air Lines’ efforts to control costs. The carrier has taken the boldest step of its North American peers toward addressing rising fuel costs, purchasing a refinery in the Philadelphia area that’s capable of processing 185,000 barrels per day.

After upgrades to the facility boost its output of jet fuel to 40,000 barrels per day, the refinery could cover about 80% of the airline’s expected fuel needs. Management estimates that the Trainer refinery will generate about $300 million in annual cost savings, as operating the facility enables Delta Air Lines to capture some of the crack spread—the profit margin from processing oil to produce jet fuel and gasoline.

While the Trainer refinery promises to reduce Delta Air Lines’ fuel costs in coming years, management has also sought to improve the fleet’s fuel efficiency. By swapping 50-seat regional jets for larger aircraft that are 30% more efficient, the airline lowers its fuel consumption and expands the opportunity to sell higher-margin amenities to passengers.

Delta Air Lines has been less successful in managing its nonfuel expenses, which increased by more than two times the industry average in 2012. Investments in additional services and amenities for its planes accounted for some of this uptick. The expiration of temporary wage reductions, agreed to when the firm was in financial trouble, also contributed to rising expenses.
 
Fortunately, management expects nonfuel expenses to peak in the first quarter of 2013 and moderate in the second half of the year, when additional cost-cutting initiatives take effect. The company aims to hold increases in nonfuel expenses to less than 1%.
 
Rising revenue, fuller flights, and progress on costs have enabled Delta Air Lines to generate $3.9 billion in free cash flow over the past three years, much of which has been allocated to reducing its debts. Management expects the company to achieve its goal of reducing its net debt to $10 billion, at which point the firm will initiate a “balanced capital deployment” strategy that could involve regular dividends and stock repurchases. Such an announcement could come as early as June 2013.

Trading at 7.5 times 2012 earnings per share and about 5.4 times projected 2013 profits, the stock’s depressed valuations reflects investors’ continued bias against airlines. With profits likely to rise at an average annual rate of 15% over the next three years, shares of Delta Air Lines are ripe for a higher multiple as investors rediscover this snake-bitten industry.

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Tickers Mentioned: Tickers: BAIRY, DAL

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