Wednesday, October 22, 2014

ANALYSIS: Delta Delivers Solid Financial Results But Worrying Signs Emerge

by Vinay Bhaskara / Published October 22nd, 2014

Disclosure: Author is long DAL


A Delta Boeing 747. All images courtesy of Airchive.

Delta Air Lines recorded a $579 million pre-tax profit for the third quarter of 2014, beating analyst estimates to yet another quarter of record profitability. On a net GAAP-basis, Delta’s profit was $357 million ($0.42 per diluted share), while excluding special items, Delta’s pre and post-tax net profit figures were $1.6 billion and $1 billion ($1.20 per share) respectively

Delta’s total revenue rose sharply, 6.6% year-over-year (YOY) to $11.17 billion, led by a 5.6 percent increase in passenger revenue to $9.78 billion. Mainline passenger revenue rose 7.6 percent YOY to $8.14 billion, while regional revenues declined 3.3% YOY to $1.63 billion, reflecting changes in Delta’s fleet and capacity mix. For the quarter, Delta took delivery of 22 aircraft but retired 34, including 24 50-seat regional jets, allowing it to generate 2 percent higher domestic capacity on a 4.5 percent reduction in departures.

Delta's Economy Comfort seats.

Delta’s Economy Comfort seats.

Reversing a worrying trend from prior quarters, cargo revenue rose a healthy 6.6 percent to $244 million. Other operating revenues, which includes revenues from Delta’s SkyMiles frequent flyer program, rose 15 percent YOY to $1.16 billion. Passenger revenue per available seat mile (PRASM) rose 2.4 percent YOY to 14.83 cents on a 1.8 percent increase in yields to 17.16 cents and a 3.2 percent increase in capacity as measured by available seat miles (ASMs).  Delta’s growth in top-line revenues was driven in part by a 6 percent rise in corporate revenues, led by the financial services, automotive, banking, and media sectors. Ancillary revenue initiatives generated $290 million in the quarter, with 20 percent growth in the Economy Comfort and First Class upsell initiatives pushing paid first class load factors up to 44 percent. Rival United Airlines has also generated a similar effect with its own up-sell scheme, though the schemes also run the risk of alienating high value frequent flyers.

Turning to specific operating segments, a summary of Delta’s revenue figures by region is shown in the table below.

Delta 3Q chart jpg

As the data indicates, Delta’s operations are currently being powered by the domestic operating segment, in line with the improved performance of the U.S. economy relative to others around the world. Within the domestic segment, New York LaGuardia’s performance outpaced other hubs with 10 percent unit revenue growth, while Seattle managed to generate a 6 percent YOY increase in PRASM despite 25 percent capacity growth. Trans-Atlantic PRASM was flat on a 4% increase in capacity, and while those figures may seem worrying at first glance, most of Delta’s growth in term of capacity is in the high-value London Heathrow market in conjunction with Virgin Atlantic, where the economic and demand fundamentals are far stronger.


Tokyo Narita Terminal 1

Currency effects continued to hammer Latin American and Pacific operations with PRASM down 5.1 percent and 2.2 percent respectively on a 16.2 percent increase in capacity YOY and a 0.5 percent decrease. Delta continues to unwind its Tokyo Narita hub as it grows capacity in Seattle, but the yen remains a substantial portion of Delta’s overall Asian revenues. Meanwhile in Latin America, growth slowdown and extreme currency devaluation in Argentina and Venezuela have hampered two of the most profitable regions in Latin America.

Turning to expenses, operating expenses rose 15.9 percent YOY to $10.3 billion, though excluding special items, the rise was just 3.6 percent YOY. Aircraft fuel expenses (excluding one-time costs) fell 1 percent YOY to $2.27 billion, driven by lower fuel prices and improved profitability at the Trainer Refinery. Other expense line items were mostly flat YOY on a per-ASM basis excepting aircraft maintenance, which declined 7.2 percent YOY to $440 million. Labor expenses rose 4.8 percent YOY to $2.07 billion, though the figure was higher including profit sharing expenses, which rose 54.2 percent to $384 million.

Turning to financial metrics, operating income for the quarter excluding special items was $1.93 billion, up 23.5 percent YOY. Delta’s operating margin for the quarter was 15.8 percent, exceeding Delta’s own targets from the past three to four years and elevating the full service airline towards operating margins normally seen exclusively by low cost carriers (LCCs) around the world. Trailing 12 months return on invested capital was 19.3 percent, positioning Delta as the top airline amongst its legacy peers. Free cash flow, an investor-targeted metric, rose to $910 million on $411 in capital expenditures.

We have been exceedingly positive on Delta’s forward looking financials in this space since it was launched but a few Delta-specific trends have us worried about short-term financial prospects. We will preface the discussion below by stipulating that we see little potential for earnings, margins, or even revenue degradation for Delta over the next ten years, our worries largely fall on the prospects of expansion of these metrics over the next 5-7 quarters. The airline industry, in our opinion, still has another 6-8 quarters left in the current positive cycle left to run through mid to late 2016.

That being said, looking at Delta’s specific trends, there are a few worrying signs. First, due to its policy of aggressive hedging and of course its operation of the Trainer refinery, Delta is not as well positioned as other US airlines to take advantage of the recent decline in the dollar-denominated oil price. Delta’s management claims that it will still be able to participate in “80 percent” of the improvement in fuel prices.


Delta Air Lines Airbus A319 at LAX Airport.

We are less sure – while the Trainer refinery did generate a $19 million profit for the quarter, it is unclear how much progress Delta has made in being able to handle an oil price that is $15 per barrel lower (West Texas Intermediate) while still operating profitably. To us, the more realistic number is 65 percent (in terms of Delta’s participation in the fuel cost decline), especially because Delta’s ability to further push down crack spread is limited. And that 65 percent number caps Delta’s earnings growth potential relative to its peers.

But the bigger worry we have for Delta is revenue, more specifically how it continues to generate PRASM growth in the current environment. Latin America is a mixed bag – some countries remain strong, while others (notably Argentina) are rapidly devolving into basket cases. Commodity prices around the world are falling, which bodes poorly for other key South American markets like Peru, Chile, Ecuador, and even Brazil and Colombia.

Meanwhile, Asian revenues are likely to suffer for the next 3-4 quarters as Seattle’s role in the overall Asian capacity mix continues to rise proportionately and those routes spool up. The plan to eliminate the 747-400 fleet by 2017 is a positive sign for margins in Asia, as is the reduction in fuel prices (which improves the operating economics of the relatively gas-guzzling Boeing 777-200LRs).

But economies in the region are in a lower growth phase (and there has been a recent surge in new service from East Asian carriers), so the PRASM environment is likely to remain rough. Delta is more exposed to Africa than either American or United, in particular West Africa, and while we think that fearing Ebola in the developed nations of North America and Europe is an overreaction, in Africa those fears intersect with demand in a tangible manner.


Delta MD-82 at Philadelphia International Airport.

But by far the largest worry is Delta’s step-up in domestic capacity. For its forward-looking 2015 capacity figures, Delta is talking about 2 percent capacity growth (implying 4 percent capacity growth in the U.S.). That 4 percent figure is worrying. It is on the higher end of our expectations for U.S. GDP growth in 2015, but more importantly, Delta and the other network and legacy airlines have reached this point of unprecedented profitability primarily because they kept capacity growth below that of GDP, allowing them to drive up fares.

And it’s not as though Delta is adding domestic capacity in fortress hubs such as Detroit or Atlanta in monopoly markets. Rather, it is throwing a ton of competitive capacity into Seattle and Los Angeles. To be clear, both of these expansions have a solid underlying strategic justification (Asia and increasing relevance for corporate travel contracts respectively). But the capacity that Delta is adding is substantial and dilutive to its PRASM.

Alaska is a fierce, lower cost competitor with a ton of embedded market loyalty, while Los Angeles is simply a bloodbath. Seattle by itself might be viable, but when paired with likely fare and capacity wars in Los Angeles, it’s difficult to see how Delta’s capacity actions won’t adversely impact margin and profitability growth. Delta’s underlying business fundamentals are of course fantastic, but in a period where airlines must count on the domestic business to drive PRASM growth, perhaps fighting a two-front war on the West Coast is not the most sensible course of action.


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