Trainer becoming a distraction, but core business solid

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1 AIRLINES Sector Weighting Market Overweight DELTA AIR LINES, INC. (DAL $20.80 Outperform) Trainer becoming a distraction, but core business solid Clean beat with EPS of $0.98 above our estimate of $0.93 mostly on non-fuel cost savings that, importantly, don t appear to be one-time in nature. More importantly, DAL grew EBIT margins y/y and guided to another quarter of y/y EBIT margin growth in 3Q. We believe investors including ultra-short term ones are more willing to accept the premise of margin expansion carrying more weight than second derivative PRASM changes (though PRASM guidance for July/Aug was good, too). Margin guidance. DAL has now come within around ~100bp of its initial margin guidance in each of the last six quarters. DAL s earnings are by far the most stable of the network airlines we cover, which we believe will help attract the incremental investor to the sector and more specifically, DAL s stock. DAL s 3Q EBIT margin guide of +11% to +13% was above our estimate by about 100bp. Trainer becoming a distraction. RIN-related issues exacerbated refinery losses, causing Trainer to lose $51M in the quarter and bringing the trailing 3Q loss there to $136M. This was an area of focus on the analyst call. There is no doubt that Trainer s jet fuel output has contributed somewhat to lower east coast jet fuel prices via higher overall domestic supply, but it s hard to quantify that benefit (which is shared by DAL s competitors, of course). Trainer might work out in the long run for DAL, but in the near term it seems to be stealing thunder from what is an otherwise compelling execution story at the core airline business. As of now, we do not view Trainer risk as a reason to avoid shares of DAL. Demand trends solid. DAL expects July/Aug PRASM growth of ~3% y/y, which was ~150bp above our expectations. That, combined with a good trajectory of nonfuel CASM means our estimates move up, as does our target price. Raising estimates and target price to $25. We affirm DAL as our top idea in airlines, a space we rate as Market Overweight, because of DAL s cash flow. DAL isn t perfect (who is?), but upside catalysts far outweigh risks, in our opinion, and the equity markets still don t seem to be extending DAL the benefit of the doubt on fiveyear cash generation potential. Our target price is based on merely 7x our higher 2014 cash EPS estimate (see estimate changes in table below). EPS (US$) 1Q 2Q 3Q 4Q FY FC Cons P/E 2013E $0.10 $0.98A $1.18E $0.54E $2.81E $2.67E 7.4x Prior 0.93E 0.99E 0.55E 2.58E 2014E 3.57E 3.04E 5.8x Prior 3.28E FC Cons = First Call Consensus, P/E based on WR estimates Trading and Fundamental Data Target Price YE 13 $ Week Range $8-$22 Market Cap. (MM) $17,870 Shares Out. (MM) Dividend/Yield $0.24/1.2% Avg. Daily Vol. (000) 9,290 Adjusted Debt to 116.0% Total Cap Short-Interest Ratio 2.3 % of Float 2.2% Book Value -$2 Free Cash Flow Yield 2.3% Source: FactSet Research Systems Inc. Price Performance YTD LTM DAL 75% 115% XAL 35% 62% S&P % 25% Source: FactSet Research Systems Inc. Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Source: FactSet Research Systems Inc. Hunter Keay, CFA (646) HKeay@WolfeResearch.com Jared Shojaian, CFA (646) JShojaian@WolfeResearch.com DO NOT FORWARD DO NOT DISTRIBUTE DOCUMENT CAN ONLY BE PRINTED TWICE This report is limited solely for the use of clients of Wolfe Research. Please refer to the DISCLOSURE SECTION located at the end of this report for Analyst Certifications, Important Disclosures and Other Disclosures. WolfeResearch.com Page 1 of 6

2 Investment Conclusion DAL closed up 2% following its 2Q earnings and earnings call, versus our WR Airline Index (ex-dal) up less than 1% and the S&P 500 down slightly. DAL is now up 75% YTD, versus our WR Airline Index (ex- DAL) up 36% and the S&P 500 up 18%. On our upwardly revised estimates DAL is trading at 6.5x rolling twelve month forward EPS versus its one and five year averages of 5.0x and 6.3x, while trading at 5.2x rolling twelve month forward EV/EBITDAR versus its one and five year averages of 4.6x and 5.1x. Key takeaways from the report and the conference call Three positive surprises: 1. July & August PRASM guidance of +3% y/y was about 150bp better than we expected it would be 2. The CASM ex-fuel beat didn t appear to be timing driven and should accelerate into 2H13 3. Fuel guidance of $3.05 to $3.10/gal was much lower than we thought, especially when factoring in what should be another tough quarter for the Trainer refinery due to RINs and core refining losses (though we are struggling to reconcile this guidance with the spot price of jet fuel, DAL s hedge book, Trainer, and other jet fuel-related expenses like taxes, etc.) Three negative surprises: 1. Higher interest rates don t appear to be having a material impact on pension savings for DAL s P&L 2. Trainer is becoming more and more complicated and hard for general investors to follow/model 3. Lots of talk of corporate market share gains for an industry that has supposedly moved past market share battles Conclusion: Today s earnings call was positive. Trainer may or may not work out for DAL in the long run, but we ll be the last analysts to play Monday morning quarterback on this issue. DAL took a risk with the Trainer acquisition, and that risk was taken with the intention of creating shareholder value (as opposed to, say, making customers happy). For now, the strategy isn t working. DAL s estimate of $300M of annual fuel savings likely won t happen, at least this year, and as the refinery losses accumulate it is distracting from what is otherwise a strong transformational story. In the meantime, DAL s network is functioning strongly and cash generation is robust. Guidance for near-term demand trends exceeded even the most bullish of estimates, in our opinion, and consensus estimates likely have room to expand. We are optimistic about the near and long term prospects for shares of DAL, and our new target price of $25 is based on 7x our higher 2014 cash EPS estimate. Longer term we can see this multiple expanding to 10x cash EPS estimates when DAL s margins are sustainably in the low double digits, as we expect will occur. We reiterate our Outperform rating on shares of DAL. More below. WolfeResearch.com Page 2 of 6

3 Key Points Expanded Below we show DAL s reported 2Q13 results compared to 2Q12 and to our estimates. Exhibit 1. 2Q13 Actual Results vs. Estimates and 2Q12 Delta Air Lines - Quarterly Actuals vs. Estimates 2Q12-A 2Q13-E 2Q13-A Difference Notes Revenues Mainline Pax 6,620 6,823 6,796 (27) Mainline PRASM grew <1% but that's pretty good when fuel/gal is down 11% % change y/y 6.7% 2.7% 2.7% 0.0pp Regional Pax 1,811 1,696 1,698 2 Regional PRASM declined 2% y/y on a 4% reduction in capacity % change y/y 7.5% -6.1% -6.2% -0.1pp Total Pax Revenue 8,431 8,520 8,494 (26) % change y/y 6.8% 0.8% 0.7% -0.1pp Cargo (9) Both volume and yields down but yields down even more % change y/y -0.8% -8.0% -11.5% -3.5pp Other 1, DAL discontinued some low-margin third-party maintenance contracts % change y/y 4.1% -5.0% -5.6% -0.6pp Total Ancillary Revenue 1,301 1,209 1,213 4 % change y/y 3.1% -5.6% -6.8% -1.2pp Total Revenue 9,732 9,729 9,707 (22) % change y/y 6.3% 0.0% -0.3% -0.2pp Consolidated Expenses 2Q12-A 2Q13-E 2Q13-A Difference Aircraft fuel and related taxes 2,744 2,475 2,470 (5) Trainer is still not profitable and RINS issue is complicating things even further % change y/y 3.5% -9.8% -10.0% -0.2pp Salaries & related costs (excluding profit sharing) 1,825 1,982 1,922 (60) Improving trends here and 2H will likely be much better than 1H as pilot deal laps % change y/y 4.9% 8.6% 5.3% -3.3pp Contract carrier arrangements 1,416 1,407 1, This line includes some fuel and some maintenance % change y/y 0.4% -0.6% 2.0% 2.6pp Aircraft maintenance materials & outside repairs (79) Tough line to model; probably no major swings in 2H % change y/y 13.0% 0.5% -13.9% -14.4pp Contracted services (10) Pulling aircraft from Comair and reallocating to other carriers % change y/y -4.3% 5.6% 3.0% -2.6pp Passenger commissions & other selling expenses Likely growth in 2H as comps get tough as tailwinds are lapped % change y/y -10.7% -1.0% 3.8% 4.8pp D&A Probably modest growth here particularly as DAL takes delivery of aircraft in 2H % change y/y 1.8% 3.4% 7.0% 3.6pp Landing fees and other rents Variable expenses so likely growing modestly in 2H with more capacity % change y/y 8.4% 0.1% 3.5% 3.4pp Aircraft rent (8) Less a/c on lease; 17th straight quarter of y/y declines % change y/y -8.1% -7.5% -19.1% -11.6pp Passenger service Variable expenses so likely growing modestly in 2H with more capacity % change y/y 3.3% -3.9% 5.3% 9.3pp Other expenses (6) Very good trends here, which could be the result of eliminating third-party contracts % change y/y -3.9% -6.2% -7.8% -1.6pp Profit sharing expense Fifth straight profitable quarter with profit sharing paid out Total Expenses 8,844 8,700 8,634 (66) Operating Income 888 1,029 1, Operating margin 9.1% 10.6% 11.1% 0.5pp Beat the high-end of initial margin guidance Interest expense, net (207) (185) (172) 13 Right near its $10B net debt target soon DAL will likely buy back stock Amortization of debt discount (49) (45) (41) 4 From the Northwest Airlines acquisition Miscellaneous/Other (42) (5) (15) (10) Total non-operating expense (298) (235) (228) 7 All the debt paydown helps reduce interest expense Pretax Income Pretax margin 6.1% 8.2% 8.7% 0.5pp Also benefiting from debt paydown Income taxes (4) - (1) (1) Tax rate 0.7% 0.0% 0.1% 0.1pp Income from Cont. Ops Add back: Convertible interest / Pref. Div Non-recurring items (754) - (159) (159) Includes mark to market hedge losses and other special charges Discontinued ops Net Income (168) (109) EPS from Cont. Ops $0.69 $0.93 $0.98 $0.06 Above us at $0.93 and consensus at $0.94 Diluted share count OPERATING STATISTICS (CONSOLIDATED) Consolidated Pax Yield Solid demand commentary and record revenue performance over July 4th weekend % change y/y 6.5% 0.3% 0.2% -0.1pp Consolidated PRASM July PRASM guidance of +3%; Expects similar improvement in August % change y/y 8.2% 0.0% -0.1% -0.1pp Consolidated CASM ex-profit sharing & ALL fuel H will likely show lowest rate of growth since 2010 % change y/y 3.8% 3.1% 2.3% -0.8pp Source: Company Reports; Wolfe Research WolfeResearch.com Page 3 of 6

4 DISCLOSURE SECTION Analyst Certification: The analyst of Wolfe Research, LLC primarily responsible for this research report whose name appears first on the front page of this research report hereby certifies that (i) the recommendations and opinions expressed in this research report accurately reflect the research analysts personal views about the subject securities or issuers and (ii) no part of the research analysts compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in this report. Important Disclosures: Price Chart with Ratings and Target Price History Note: OP = Outperform; PP = Peer Perform; UP = Underperform Wolfe Research, LLC Fundamental Valuation Methodology: Company: Fundamental Valuation Methodology: DAL Forward P/E Wolfe Research, LLC Fundamental Target Price Risks: Company: Fundamental Target Price Risks: DAL Rising jet fuel prices; Exogenous shock events (terrorist attack, disease outbreak, etc.); DAL fails to reduce leverage or deploy cash to shareholders; Pricing environment softens causing margins to contract Wolfe Research, LLC Research Disclosures: Company: Research Disclosures: DAL None Other Disclosures: Wolfe Research, LLC Fundamental Stock Ratings Key: Outperform (OP): The security is projected to outperform analyst's industry coverage universe over the next 12 months. Peer Perform (PP): The security is projected to perform approximately in line with analyst's industry coverage universe over the next 12 months. Underperform (UP): The security is projected to underperform analyst's industry coverage universe over the next 12 months. Wolfe Research, LLC uses a relative rating system using terms such as Outperform, Peer Perform and Underperform (see definitions above). Please carefully read the definitions of all ratings used in Wolfe Research, LLC research. In addition, WolfeResearch.com Page 4 of 6

5 since Wolfe Research, LLC research contains more complete information concerning the analyst s views, please carefully read Wolfe Research, LLC research in its entirety and not infer the contents from the ratings alone. In all cases, ratings (or research) should not be used or relied upon as investment advice and any investment decisions should be based upon individual circumstances and other considerations. Wolfe Research, LLC Sector Weighting System: Market Overweight (MO): Expect the industry to outperform the primary market index for the region (S&P 500 in the U.S.) by at least 10% over the next 12 months. Market Weight (MW): Expect the industry to perform approximately in line with the primary market index for the region (S&P 500 in the U.S.) over the next 12 months. Market Underweight (MU): Expect the industry to underperform the primary market index for the region (S&P 500 in the U.S.) by at least 10% over the next 12 months. Wolfe Research, LLC Distribution of Fundamental Stock Ratings (As of June 30, 2013): Outperform: 42% 4% Investment Banking Clients Peer Perform: 43% 0% Investment Banking Clients Underperform: 15% 0% Investment Banking Clients Wolfe Research, LLC does not assign ratings of Buy, Hold or Sell to the stocks it covers. Outperform, Peer Perform and Underperform are not the respective equivalents of Buy, Hold and Sell but represent relative weightings as defined above. To satisfy regulatory requirements, Outperform has been designated to correspond with Buy, Peer Perform has been designated to correspond with Hold and Underperform has been designated to correspond with Sell. Wolfe Research Securities and Wolfe Research, LLC have adopted the use of Wolfe Research as brand names. Wolfe Research Securities, a member of FINRA ( is the broker-dealer affiliate of Wolfe Research, LLC and is responsible for the contents of this material. Any analysts publishing these reports are dually employed by Wolfe Research, LLC and Wolfe Research Securities. The content of this report is to be used solely for informational purposes and should not be regarded as an offer, or a solicitation of an offer, to buy or sell a security, financial instrument or service discussed herein. Opinions in this communication constitute the current judgment of the author as of the date and time of this report and are subject to change without notice. Information herein is believed to be reliable but Wolfe Research and its affiliates, including but not limited to Wolfe Research Securities, makes no representation that it is complete or accurate. The information provided in this communication is not designed to replace a recipient's own decision-making processes for assessing a proposed transaction or investment involving a financial instrument discussed herein. Recipients are encouraged to seek financial advice from their financial advisor regarding the appropriateness of investing in a security or financial instrument referred to in this report and should understand that statements regarding the future performance of the financial instruments or the securities referenced herein may not be realized. Past performance is not indicative of future results. This report is not intended for distribution to, or use by, any person or entity in any location where such distribution or use would be contrary to applicable law, or which would subject Wolfe Research, LLC or any affiliate to any registration requirement within such location. For additional important disclosures, please see The views expressed in Wolfe Research, LLC research reports with regards to sectors and/or specific companies may from time to time be inconsistent with the views implied by inclusion of those sectors and companies in other Wolfe Research, LLC analysts research reports and modeling screens. Wolfe Research communicates with clients across a variety of mediums of the clients choosing including s, voice blasts and electronic publication to our proprietary website. Copyright Wolfe Research, LLC All rights reserved. All material presented in this document, unless specifically indicated otherwise, is under copyright to Wolfe Research, LLC. None of the material, nor its content, nor any copy of it, may be altered in any way, or transmitted to or distributed to any other party, without the prior express written permission of Wolfe Research, LLC. WolfeResearch.com Page 5 of 6

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