Market Insight – Unity Software & Delta Air Lines
In this edition of Business Insight, we will dive into Delta's Q4 results and Unity's recent announcement to lay off 25% of its workforce, and see what this means for either investment case.
Delta Air Lines shares are compelling after reporting Q4 results
The earnings season kicked off last Friday with many of the U.S. big banks reporting their Q4 results, but it was not just the big banks reporting. Every quarter, Delta Air Lines is one of the first companies to report its quarterly earnings and is a crucial indicator for the performance of the entire airline industry. This is due to Delta, apart from reporting first, being the largest publicly traded and most well-established, globally recognized airliner with a market cap of $27 billion and annual revenue exceeding $55 billion.
For reference, Delta Air Lines is a major American airline that operates both domestic and international flights. Headquartered in Atlanta, Georgia, Delta is one of the largest and oldest airlines globally. With a vast fleet and an extensive network of destinations, the airline plays a significant role in the aviation industry. It flies to 352 destinations across 52 countries and operates over 5,400 flights daily using its fleet of 978 aircraft, operating one of the world’s largest fleets of both Airbus and Boeing planes.
Safe to say, the company is a fine industry benchmark, which is why its quarterly results are quite important for the industry as a whole. So, let’s see how it performed in Q4.
Delta beat the Q4 consensus on top and bottom lines, beating the revenue consensus by 3% and EPS by a very solid 10%. Delta reported revenue of $14.22 billion, up 5.8% YoY. Furthermore, this strong Q4 performance led to it reporting $58 billion of revenue for the full year, 20% above pre-pandemic levels.
Nevertheless, Delta shares lost close to 9% in the following trading session, as did many of its airline peers. American Airlines and United Airlines lost 9.5% and 10.5%, respectively, in the same trading session.
According to Delta’s president, Glen Hauenstein, the company continues to see strong demand, with demand for international travel offsetting some of the domestic weakness. In recent months, some carriers have faced an oversupply of domestic flights, which has put pressure on margins, but this pressure is easing.
Nevertheless, this was still visible in Delta’s quarterly results as revenue per available seat mile was down to $0.1995 against $0.2066 a year ago, and cost per available seat increased slightly to $0.1329 from $0.1314. Nothing too impactful or shocking, though. For reference, Delta still derives 62% of its revenue from the U.S.
Positively, Delta has no Boeing Max-9s in its fleet, so it is not directly impacted by the Boeing incident from last Friday. Management even said it saw a slight uptick in bookings in the Seattle area where Alaska Airlines is based, which does face headwinds from the incident.
However, we should add that Delta has dozens of orders outstanding for Boeing 737 Max-10 aircraft, which could potentially face some delays if the FAA takes longer to certify these models following last week’s incident. This is something we deem likely at this point.
Positively, Delta also announced on Friday that it ordered another 20 wide-body Airbus A350-1000 aircraft, with deliveries starting in 2026, an announcement that we don’t believe is a coincidence. Meanwhile, Delta will continue to focus on building out its fleet to be able to keep up with the growing demand for international travel, which is why all these aircraft orders are of great importance.
Also worth pointing out here, in a very competitive industry often facing a shortage of staff, is that Delta is recognized as the world’s 12th most admired company by Fortune and as the 13th best employer in the U.S. Staggeringly, Delta’s Valentine’s Day upcoming profit sharing will be double that of last year and more than its three largest competitors combined. Clearly, Delta will be the preferred workplace for employees, giving it an edge in a tight labor market, an important factor that should not be overlooked by investors.
Moving to the bottom line, the company performed strongly here and saw significant improvements from the prior year as cash flows also returned to pre-pandemic levels.
Q4 operating income fell slightly YoY to $1.33 billion as the operating margin dipped to 9.7%, down 190 bps YoY. This was the result of a 13.4% jump in operating expenses, outpacing revenue growth even as the cost of fuel per gallon was $3.00 vs. $3.20 a year ago. This led to a net income of $826 million, also down slightly from last year. This translated into an EPS of $1.28, down 13.5% YoY.
For the full year, Delta reported EPS of $6.25, which is almost double the number reported in 2022, while revenue was up only 20%, highlighting significant cost improvements. Furthermore, despite the dip in Q4, operating income in FY23 was up 78% YoY as the operating margin improved by 380 bps to an industry-leading 11.6%, which is impressive.
This also allowed the net income to double YoY and FCF to come in at $2 billion, which is really decent, especially as Delta continued to invest heavily in the business with $5.3 billion of Capex or 9% of revenue. These strongly improved cash flows also allowed Delta to repay $4 billion of gross debt, which meant it ended the quarter with $17.1 billion in debt, down close to $10 billion from the end of 2020. Furthermore, it held $2.7 billion in cash on the balance sheet, leaving it in a much healthier position compared to the last few years.
Moreover, management now guides for another uptick in FCF in 2024 to $3-4 billion, up 75% at the midpoint from this year’s 2 billion. Therefore, management aims to keep retiring debt in 2024, aiming for a $3 billion reduction, bringing the company closer to an investment-grade balance sheet again.
Crucially, this improved financial position also allowed it to reinstate a dividend of $0.20 annually, translating into a yield of just 0.47% but also a payout ratio of just 3%. While this might not seem very meaningful yet, it is an important step for the company and investors to become more attractive again.
However, the thing investors focused on with the Q4 result was guidance, and this is where bulls were disappointed. According to Morgan Stanley analysts, the drop in share price was most likely the result of the bull’s disappointment with the in-line guidance and guidance below its long-term targets, projecting some sort of weakness. Still, a 9% drop on steady results and guidance in line with the consensus is harsh at the very least.
Diving a little deeper into guidance, Delta is now guiding for Q1 revenue to be up 3% to 6% on capacity growth of 6%. Furthermore, Delta guides for an EPS of $0.25 to $0.50 based on an operating margin of 5%. We should not forget that the winter months are somewhat slower for airlines, resulting in a lower operating margin in these months.
For FY24, Delta guided for EPS of $6.00 to $7.00, with the midpoint in line with the consensus but below Delta’s long-term profit target, which pointed to several years with EPS of above $7.
FY24 capacity should grow by 3% to 5%, which is also below the mid-single-digit range management communicated during its June investor day, which is what really disappointed investors. Management changing its long-term guidance six months after its investor day sure isn’t great.
What is great is that, as stated earlier, Delta expects to report FCF of $3 billion to $4 billion, driven by growth and profitability and lower CapEx.
Across the board, I don’t think this guidance is bad at all and view the market’s reaction to the results as overdone. Based on the current analyst consensus, shares are valued at just 6x this year’s earnings, which is a much-deserved premium over close peers United and American Airlines and a 30% discount to its 5-year average.
All in all, I believe the company deserves to be valued at a premium and that an 8x multiple is more than fair, which would translate into a price target of $52. Wall Street analysts currently have a “strong-buy” rating on Delta, with 100% of analysts being buy-rated with a price target of $55, presenting a staggering 43% upside.
While I generally avoid airlines as well as car manufacturers and gas and oil giants, each for its own reasons, I can’t go around the fact that from a current price point, Delta is looking quite interesting, especially considering the progress the company is making on a financial front.
While this doesn’t mean I am now buying Delta shares hand over fist, I have added the company to my shortlist as I see significant upside, and its excellent execution and global leadership make it a top pick.
At InvestInsights, we believe this recent share price dip following a solid Q4 report offers an attractive buying opportunity in a superior industry leader with strong cash flows.
Unity lays off 25% of its workforce, raising questions
At the start of last week, we were quite shocked by the news that Unity Software will lay off 25% of its workforce, or about 1,800 jobs. This comes on top of the 600 employees that were laid off at the start of the year, or about 8% of the workforce, which are staggering numbers for a company that should be seen as a high-growth tech company because apart from that, it has little going for it. These are highly concerning developments, to say the least.
To put this into context, Unity Software is a leading technology company specializing in creating and providing a comprehensive platform for the development of interactive 2D, 3D, augmented reality (AR), virtual reality (VR) experiences, and game development. The company's platform enables developers to build immersive and engaging content across various industries, including gaming, film, automotive, architecture, and more. Unity is known for its versatile tools and solutions that empower creators to bring their visions to life, fostering innovation and collaboration in the digital realm.
Furthermore, Unity does, in fact, lead the game engine market with a market share of 40%, followed by Epic Games, whose popular Unreal Engine game engine is also a popular choice among developers, capturing a 30% market share. Together, these two hold a very powerful duopoly, and these two platforms are incredibly important to small and medium businesses and game developers. In fact, 53 of the top 100 gross mobile games have been developed using Unity’s game engine, showing its importance. This market share is not easily thrown away either, as the company has a growing competitive advantage in the industry due to its high switching costs. Furthermore, this market is projected to grow by double digits for the foreseeable future, driven by the growing video game market and new technologies such as VR and AR.
So, how is this company not functioning properly, and why is it laying off over a quarter of its workforce in just over a year? Clearly, the potential should be there.
Well, financially, across the board, the company has not been able to develop in the right direction despite a rapidly growing top line. Illustrating this, since the 2022 IPO, the gross margin has fallen by seven percentage points, and the operating margin has deteriorated from -36% in 2022 to -38% in the latest quarter.
Furthermore, prior CEO John Riccitiello had been on an acquisition spree in recent years, including some large acquisitions like Ironsource for $4.4 billion and Weta Digital for $1.6 billion. However, while these acquisitions have strengthened the company’s competitive position, goodwill now stands at $3.2 billion, representing a staggering 43% of total assets, which is far from great.
Meanwhile, Wall Street has started demanding actual profits over the last year as the company hasn’t been delivering on other fronts either. In a search for this, layoffs are often a relatively easy lever to pull. This has benefitted the company over the last year already, after laying off 8% of the workforce at the start of 2023.
According to the company, these latest layoffs were part of a corporate restructuring plan. They should result in even more efficiency gains in Q1 as the company continues to face high costs. Further helping these margin and efficiency improvements are the synergies it looks to exploit from recent acquisitions and by reviewing G&A expenses.
Analysts from Jefferies call the reduction in the workforce painful but necessary. Meanwhile, JPMorgan analysts also supported the move and expect it could result in a reduction of $400 million in annualized operating expenses or about 16% based on 2023 financial data, which bodes well for the company in its efforts to boost profitability.
Yet, while job cuts were announced and expected, the severity of these surprised Wall Street and investors alike, and not in a positive way. The 25% cut implies that Unity management most likely expects a more severe slowdown in revenue than the market had anticipated, allowing it to cut these jobs. This is reflected in the revised analyst estimates with 20 revenue downward revisions and the analyst consensus pointing to revenue growth of just low to mid-teens growth, which is a significant slowdown from the expected 54% growth in FY23.
At the end of the day, what investors look for in Unity is impressive top-line growth and portfolio expansion, so while these cost cuts and efficiency gains are all nice and well, this will be a drag on the company’s ability to grow, which is why these recent layoffs were not particularly well received.
On top of this, cutting away 25% of your workforce will not help you get the best talent in the door, which is precisely what Unity needs. In fact, following the recent layoffs, the founders of Ironsource, which Unity acquired 14 months ago for $4.4 billion, announced they are also leaving the company, which is no positive thing in my book. These are guys with a lot of expertise who build Ironsource from the ground up. Losing these minds is something I believe is quite a significant loss.
Also, considering some important metrics, it is worth pointing out that the company sees a net retention rate of just 102%, reports stock-based compensation at 32%, and, in the most recent quarter, still reported a GAAP net loss margin of 23% despite some efficiency gains from personnel cuts at the start of the year. However, it is also worth pointing out that margins have been improving across the board throughout the year, with the Q3 EBITDA margin up to 24% from a negative 10% in 2022 and from 6% in Q1. But at what cost…
Finally, on a somewhat positive note, a development to write down is the release of the Apple Vision Pro in a couple of months, which could start a shift to the broader acceptance of high-quality AR devices. This could cause higher demand for Unity’s software and spur a new growth cycle, fueling some sort of bull case.
I think it is essential to make clear here that the investment thesis for Unity is far from broken. The company is still an industry leader in an exciting industry. Moreover, the company still has plenty of opportunities for growth and a strong and respected product offering, which has earned it a very loyal customer base. However, it has missed a strong leadership team so far, and I don’t view the current interim CEO as the solution either.
For now, Unity remains an avoid for us but could also be perceived as a speculative buy or turnaround play, depending on your risk profile and vision. The fundamentals are compelling, but the company must start executing much better.
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