It's always interesting to monitor stocks to buy during earnings season if the market overreacts to any negative news. With that in mind, I think Delta Air Lines (NYSE: DAL) and Hexcel Corporation (NYSE: HXL) are worth a look. Both stocks were sold off recently, and I think the market is treating them a little too harshly. Here's why.
Delta Air Lines and market cyclicality
Supply and demand set prices in a free market, and that's the case in the airline industry. As such, airlines can raise prices when demand exceeds supply, but they will suffer yield pressure when the latter occurs. Unfortunately, the airline industry has experienced cycles of feast and famine, with airlines historically maintaining high capacity during challenging periods.
With the industry commentary over, it's time to turn to what's happening now. It's clear that after a period of strong demand growth -- not least due to passengers catching up on travel plans postponed due to the pandemic-related lockdowns -- airlines have significantly expanded capacity such that supply exceeds demand. The result is that airlines like Delta Air Lines and United Airlines have reported slightly disappointing second-quarter earnings and given moderate-looking third-quarter guidance.
For example, Delta Air Lines anticipates a 2% to 4% increase in third-quarter revenue despite projected 5% to 6% growth in capacity, indicating pressure on yield.
This time it's different?
Although those are among the most famous last words in investing, they may ring true in this case. In a perfect world, market participants tend to incrementally "price in" risk as it increases. However, in reality, they often refuse to do so until one big shock event comes along to change perceptions for a while. I think the pandemic was that shocking event, and the airline industry may well learn to be more reactive,in cutting capacity when demand exceeds supply, as it does now.
That seems to be the view of Delta's management, with President Glen Hauenstein noting that "I've never seen the industry react so quickly to an oversupply" and "the industry has already reacted. And I think that's very different than it was years ago where it would stay for prolonged periods of time" on the recent earnings call.
CEO Ed Bastian noted that cutting capacity was the first lever that loss-making airlines could pull to improve performance.
United Airlines' management feels the same, with CEO Scott Kirby arguing that industry capacity exceeded demand in the second quarter. However, the industry rationalization is already taking place, with Kirby saying you can see it "happening in earnest in the second half of August in the schedules" and "As a result, it appears that the domestic industry capacity growth will moderate by roughly 5 points by the fourth quarter compared to where we were in the second quarter."
As such, don't be surprised if pricing conditions improve through the third quarter, and given that the low point of Delta's full-year guidance of $6 to $7 puts it on 7.6 times 2024 earnings, the stock looks like an excellent value.
That said, investors need to bear in mind that the recent CrowdStrike software update incident caused Delta to make thousands of flight cancellations and will need to make reimbursements to customers and could face charges in the third quarter. As such, cautious minded investors many want to wait to here management's update on the matter and a likely impact on earnings in the third quarter before buying in.
Hexcel's near-term challenges
A producer and seller of advanced graphite composites for the aerospace, space and defense, and industrial sectors, Hexcel suffers near-term headwinds in its commercial aerospace-related end markets, but for entirely different reasons.
Around 60% of its sales go to the commercial aerospace industry, with almost all of that figure going to Airbus, Boeing, and its subcontractors. About 39% of its total sales went to Airbus and its subcontractors in 2023, with Boeing and its subcontractors accounting for 15%.
As such, when Airbus and Boeing reduce their airplane delivery expectations (as they did in 2024), Hexcel will see it in its sales. There's very little aftermarket demand for its products, so airplane production is its key end market.
Unfortunately, Hexcel reduced its full-year guidance on its second-quarter earnings call:
Full-year sales are now expected to be between $1.9 billion and $1.98 billion, decreasing from the previous range of $1.925 billion to $2.025 billion.
Full-year adjusted diluted EPS is now expected to be $2.02 to $2.18, down from the previous range of $2.10 to $2.30.
A great growth at a reasonable price stock
The reduction in expectations is disappointing, especially given that Hexcel was increasing capacity to prepare for a bigger ramp in airplane production in 2024, so its margins will be soft, too.
That said, Airbus and Boeing still have multiyear backlogs, and the primary way they can increase profits is by delivering more airplanes, particularly as profit margins tend to increase as delivery volume does.
Management's revised guidance calls for about $200 million in free cash flow (FCF) this year with more than $800 million cumulatively from 2024 to 2026. Those figures would put Hexcel on 26 times its 2024 FCF, and less than 20 times FCF assuming an average FCF of a third of $800 million. That's too cheap for a company that is highly likely to grow long-term revenue as airplane deliveries ramp up and newer airplanes use more advanced composite content.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends CrowdStrike. The Motley Fool recommends Delta Air Lines and Hexcel. The Motley Fool has a disclosure policy.
2 Great Stocks to Buy on a Dip This Earnings Season was originally published by The Motley Fool