Delta Looks to Structural Changes to Fight Rising Fuel Costs

Rising fuel bills significantly hampered profitability across the U.S. airline industry in 2011. As political unrest in the Middle East pushed oil prices up this past year, most U.S. airlines saw their fuel bills jump anywhere between 30% and 50% y-o-y in FY 2011. Both Delta Air Lines (NYSE:DAL) and United Continental (NYSE:UAL) braved the impact of close to $3 billion in higher fuel bills in FY 2011. However, the airlines were able to mitigate the fuel-cost pressures by a mix of fare hikes, corporate share gains, new merchandising revenues, capacity discipline and fuel-hedging.

The past year, we saw Delta passing along the increase in input costs to customers in form of regular increases in ticket prices while at the same time working to manage the volatility of fuel expense through hedging. In 2011, Delta’s fuel hedging program generated $450 million in saving net of all premium costs. The carrier expects the fuel prices to remain at current levels or higher in near future, and intends to respond by keeping capacity in equilibrium with demand and fuel price. In order to mitigate this impact on a sustainable basis, Delta is also actively focusing on non-fuel cost control. During the Q4 2011 earnings call, the airline said, “Our biggest opportunity in 2012 is to improve our cost structure and effectively manage our fuel expense”. Below, we discuss Delta’s action plan to reduce its non-fuel costs in detail.

See our complete analysis for Delta Air Lines’s stock

Managing fuel-cost pressures with non-fuel cost control

Delta has an opportunity to lower its maintenance spend following its re-fleeting decision and the commercial agreement with AeroMexico announced in 2011 where the two airlines will expand maintenance, repair and overhaul capacity to create the largest airline MRO facility in Mexico. The order for 100 Boeing 737-900ER placed this August, promises significant savings from lower fuel burn and lower maintenance costs. The improvement in fuel consumption per seat with the addition of Boeing 737-900ER aircraft is estimated at 15% to 20%. The deliveries are scheduled over 2013-2018 and Delta expects the maintenance reductions in advance of those deliveries to begin in late 2012.

Besides banking on maintenance savings, Delta is also relying on improvement in employee productivity to reduce its non-fuel costs. The airline intends to return to historic productivity levels by focusing on resolving labor representation issues which could smooth the path to harmonize work rules and improve productivity levels for frontline employees. Additionally, technology investments would aid in enhancing efficiencies in crew systems.

Another structural change that Delta is looking at is changing the composition of its fleet by eliminating more smaller gauge aircraft. The carrier is restructuring its regional carrier contracts and reducing the 50-seat lift as it up-gauges. Up-gauging allows for more efficient capacity generation on smaller fleet count.

The carrier is guiding the March quarter non-fuel unit costs to be up 3% to 5% from prior year, the main drivers of the increase being higher selling-related expenses; employee investments, including wage harmonization; strategic initiatives, including the implementation of the LaGuardia slot swap and the new Atlanta international terminal; and the impact of the March quarter 3% to 5% capacity reduction.

We have a Trefis price estimate of $10.36 for Delta Air Lines’s stock, about 5% behind the market price on the last close. We are currently in the process of updating our model to incorporate the latest company guidance released along with FY 2011 financial results.

Understand How a Company’s Products Impact its Stock Price at Trefis