Delta’s Profit Will Likely Be Clipped By Special Charges Despite Solid Operating Performance

Delta Air Lines (NYSE:DAL) will announce its third quarter results Thursday, October 16. The third largest network carrier in the U.S., after American (NASDAQ:AAL) and United (NYSE:UAL), is coming off a strong first-half in which its profits rose sharply driven by rising demand for air travel in the domestic U.S. market. Gains from cost cutbacks, which Delta initiated around a couple of years back, also contributed to its profit growth in the first-half of 2014. In the third quarter however, we anticipate Delta’s profits to be impacted by one-time charges resulting from the early retirement of its 747-400 aircraft. Delta has been restructuring its Pacific network, including reducing its intra-Asia flights and building out its trans-Pacific network out of Seattle. As a result of this restructuring, the carrier has retired a few of its older Boeing 747-400 aircraft’s, which are the largest airplanes in Delta’s fleet. Even though these airplanes constitute a small fraction of Delta’s overall fleet (at the end of 2013, Delta operated 16 747-400s, compared to its overall fleet size of 743 airplanes), their early retirement will result in about $600 million in one-time charges on the carrier in the third quarter. ^[1] Additionally, in an investor update filed by Delta earlier in October, the carrier indicated that it will incur another $350 million in special charges in the third quarter due to a negative impact from fuel hedge settlements. ^[2]

In our view, though these special charges will clip Delta’s third quarter profit, the carrier’s long term profit outlook is bright driven by its ongoing solid operating performance. In the third quarter, excluding the impact from these special charges, Delta’s operating margin is expected to rise to 15-16% on gains from capacity expansion and cost cutbacks, up from 13% in the same period last year. ^[2] We figure because of variability in special charges, the exclusion of these charges is helpful to analyze the company’s core recurring operating performance.

We currently have a stock price estimate of $39.25 for Delta, around 20% ahead of its current market price.

See our complete analysis of Delta Air Lines here

Cost Cutbacks Will Likely Expand Third Quarter Operating Margin

About two years back, Delta initiated large scale cost cutbacks in an attempt to limit growth in its non-fuel unit costs, as measured by non-fuel costs per available seat mile (non-fuel CASM). Non-fuel CASM is a standard metric used in the airline industry to measure an airline’s cost efficiency. Fuel costs are excluded from this metric to more accurately assess how well an airline manages the costs it can control. The cost reduction which Delta initiated two years back included domestic fleet restructuring and employee headcount reduction. Over the past couple of years, these measures have helped bring down growth in the carrier’s non-fuel CASM to under 2%, on a year-over-year basis. In the third quarter, the carrier anticipates this growth in its non-fuel CASM to remain under 1%, on a year-over-year basis. ^[2] We figure this low growth in Delta’s non-fuel costs will play a key role in its operating margin expansion in the third quarter.

Capacity Expansion Will Drive Growth In Third Quarter Top Line

Additionally, with growth in non-fuel costs under control, Delta has focused on expanding its top line to grow its profits. Accordingly, the carrier expanded its flying capacity at a healthy rate of 3% annually in the third quarter. ^[2] Given the solid demand for air travel both in domestic and major international markets, this higher capacity was well absorbed. In effect, Delta’s passenger traffic will likely rise at a healthy rate in the third quarter, growing its overall revenue.

Separately, compared with other large network carriers, Delta has been able to expand its flying capacity at a higher rate. We figure this is so because Delta has employed an effective network strategy which has focused on expanding flight services out of major markets, especially New York and Seattle. (Read Effective Network Strategy Will Help Delta Maintain Its Growth Momentum)

All in all, we anticipate Delta to show solid core operating performance with a healthy operating margin in the third quarter. Though, the carrier’s GAAP profit will likely be clipped by special charges.

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1. Delta’s 2013 10-K, October 13 2014, www.delta.com [↩]
2. Delta’s October 2014 investor update, October 2 2014, www.delta.com [↩] [↩] [↩] [↩]