I recently purchased a PA position in Delta Airlines. Here is my investment case:

1. Market Consolidation

The US airlines market has consolidated substantially over the last decade or so, and is now in a position where four operators (Delta, United, American/US and Southwest) dominate the market. The extent of this consolidation can be seen in the graphic below.

The result of this consolidation should be more capacity restraint, higher prices and less cyclicality. The Economist explains why here.

2. Operational efficiencies

As a company with significant historical baggage, Delta has lots of opportunities to drive margins by improving the efficiency of its operations. As one example, it is replacing 50 regional jets with Boeing 717’s. The CEO explains how this will lead to better margins:

“Let me give you an example. Birmingham, Alabama, previously we would serve that nine times a day with 50-seaters. Now we can go to six times a day with a mainline airplane. Three class service, fewer takeoffs and landings and the awesome thing is, in 2014, we're going to have about 1.8% bump in capacity, which is less than GDP, and we’re going to do it with 10 fewer airplanes in the fleet. 10 fewer airplanes in the fleet means we’re going to drive operating leverage into the enterprise, deal with 10 fewer airplanes and you hold headcount flat, then you get margins – you get operating expansion. You get margin expansion because that bit of – that little pieces of very – this business is very much prone to being able to drop that to the bottom line.”

Read the recent investor day presentation and management transcript to get a better idea of how management are going to achieve this.

3. Cash flow generative

Delta is expecting to generate $5bn+ of operating cash flow per annum over the next few years, with 50% being reinvested in the business and the other 50% being available to reduce debt and return to shareholders. This $2.5bn equates to a free cash flow yield of 9.3%. Assuming the EV/EBITDA ratio remains constant as debt is reduced, this means the market capitalisation has to increase be an equal amount to compensate. In addition, a reduced debt load should mean that Delta’s credit spreads should compress, further reducing interest costs and boosting free cash flow.

4. Re-rating potential

To understand what is possible when an airline improves its operations and increases shareholder returns against a backdrop of a strong economy, take a look at how European airline easyJet (white) has seen its P/E ratio re-rated over the past few years. I believe there is much more upside in Delta (yellow) from a re-rating of the shares.

Referring back to the current free cash flow yield above of 9.3%, I could easily see this falling to 5% as the shares re-rate. This would imply a share price of $58.

5. Technicals

I’m no expert on technicals, but the little I do know tells me that owning stocks that are making 52 week highs in a sector where other stocks are also making 52 week highs is a sensible thing to do. Positive share price momentum tends to show persistence.

Follow me on Twitter at @spbaines.