Is Delta Air Lines a Cash King?

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As an investor, it pays to follow the cash. If you figure out how a company moves its money, you might eventually find some of that cash flowing into your pockets.

In this series, we'll highlight four companies in an industry, and compare their "cash king margins" over time, trying to determine which has the greatest likelihood of putting cash back in your pocket. After all, a company can pay dividends and buy back stock only after it's actually received cash -- not just when it books those accounting figments known as "profits."

Today, let's look at Delta Air Lines (NYS: DAL) and three of its peers.

The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow actually backs up its reported profit. Companies that can create 10% or more free cash flow from their revenue can be powerful compounding machines for your portfolio. A sustained high cash king margin can be a good predictor of long-term stock returns.

To find the cash king margin, divide the free cash flow from the cash flow statement by sales:

Cash king margin = Free cash flow / sales

Let's take McDonald's as an example. In the four quarters ending in December, the restaurateur generated $7.15 billion in operating cash flow. It invested about $2.73 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.73 billion) from its operating cash flow ($7.15 billion). That leaves us with $4.42 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking McDonald's sales of $27.0 billion over the same period, we can figure that the company has a cash king margin of about 16.4% -- a nice high number. In other words, for every dollar of sales, McDonald's produces more than $0.16 in free cash.

Ideally, we'd like to see the cash king margin top 10%. The best blue chips can notch numbers greater than 20%, making them true cash dynamos. But some businesses, including many types of retailing, just can't sustain such margins.

We're also looking for companies that can consistently increase their margins over time, which indicates that their competitive position is improving. Erratic swings in margins could signal a deteriorating business, or perhaps some financial skullduggery; you'll have to dig deeper to discover the reason.

Four companies
Here are the cash king margins for four industry peers over a few periods:

CompanyCash King Margin (TTM)1 Year Ago3 Years Ago5 Years Ago
Delta Air Lines4.5%4.7%(14.2%)3.3%
Southwest Airlines2.7%8.8%(22.2%)0.1%
United Continental Holdings4.2%6.4%(8.5%)6.1%
Alaska Air Group4.6%8.8%(6.6%)(7.0%)

Source: S&P Capital IQ.

None of these companies meets our 10% threshold for attractiveness. Delta Air Lines, United Continental Holdings (NYS: UAL) , and Alaska Air Group (NYS: ALK) all offer current margins in the 4% range. All of these companies have seen fluctuations in their margins over the five-year period, but Delta and Alaska Air have actually seen their margins increase from five years ago, while United Continental has seen its margins decrease. Southwest Air Lines (NYS: LUV) has the lowest margins of the listed companies, and has also seen its margins fluctuate over the five-year period. However, its current margins are also better than they were five years ago.

The airline industry suffered a great deal from a decrease in business and personal travel during the economic recession, when individuals and businesses were looking for ways to cut back on unnecessary spending. The industry also had to deal with increases in fuel prices, which cut even further into their profit margins. Like many other airlines, Delta survived by charging fees for baggage and food, in addition to fuel surcharges, which helped the company cover its expenses. While these fees helped Delta survive past challenges, the company continues to face the threat of rising fuel prices. In order to be successful in the long term, it needs to find a way to successfully face the fundamental challenges of the airline industry.

The cash king margin can help you find highly profitable businesses, but it should only be the start of your search. The ratio does have its limits, especially for fast-growing small businesses. Many such companies reinvest all of their cash flow into growing the business, leaving them little or no free cash -- but that doesn't necessarily make them poor investments. Conversely, the formula works better for slower-growing blue chips. You'll need to look closer to determine exactly how a company is using its cash.

Still, if you can cut through the earnings headlines to follow the cash instead, you might be on the path toward seriously great investments.

Want to read more about Delta Air Lines? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.

At the time this article was published Jim Royal owns shares of McDonald's.Motley Fool newsletter serviceshave recommended buying shares of Southwest Airlines and McDonald's. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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