Delta’s Profits Surge, Plans To Cut International Capacity To Improve Margins

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Delta Air Lines

Delta Air Lines (NYSE:DAL) kickstarted the earnings season by announcing its first quarter operating results on Wednesday, a week ahead of all major US airlines. The airline’s stock price soared close to 5% in the last two days, as the airline managed to post net income of $746 million, almost triple what it recorded in the same quarter last year, despite a seasonally weak quarter. However, the major highlight of the earnings release [1] was the announcement of a cutback in international capacity in the following quarters to reduce exposure to markets that are facing currency fluctuations. Our price estimate for Delta stands at $46 per share, slightly above its current market price.

See our complete analysis for Delta here

A Good Quarter driven by Capacity Additions

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The Atlanta-based airline registered its most successful March quarter, both operationally and financially, as its revenue rose to $9.39 billion, a 5.3% increase year-on-year, on a capacity increase of 5% during the quarter. While revenue was largely in line with the analysts’ estimate, Delta’s passenger unit revenue (PRASM) declined 1.7% year-on-year, slightly higher than the 1.5% drop projected by the airline earlier this month [2]. While domestic unit revenue increased 2.1% on capacity growth of 7%, concentrated mostly in Seattle and New York-JFK, the airline’s international unit revenue suffered due to foreign currency weakness, particularly in the Pacific region, which experienced a 9.2% decline in unit revenue primarily due to the weakening of the Japanese Yen.

On the expense side, Delta’s average fuel price dipped from $3.03 per gallon in March 2014 to $2.93 per gallon in the latest quarter. However, the carrier could not take complete advantage of the prevailing low oil prices due to hedging losses of $1.1 billion. The non-fuel unit costs (excluding profit sharing and one-time items) dropped 1.4% on a year-on-year basis. Overall the first-quarter operating expenses fell to about $7.9 billion, a 3.7% decline from the same quarter in the last year. Consequently, Delta reported an operating margin of 8.8%, representing operating profit of $1.4 billion, more than double the $620 million recorded a year ago. The airline earned net income (excluding one-time items) of $372 million or 45 cents per share, beating market expectation of 44 cents per share.

As announced in its investor update on 2nd April, Delta returned $500 million to its shareholders through dividends and share repurchases. The airline also contributed over $900 million in pension plans and recorded $136 million as profit sharing expense during the quarter.

International Capacity Cuts To Improve Margins

Delta’s international operations, which account for over 30% of its total sales, have been struggling due to the strong US dollar and increased competition from foreign airlines, particularly the Persian Gulf carriers. As a result, the airline has announced a reduction of 3% in its international capacity in the coming quarters. This pullback will be focused on markets such as Japan, Brazil, Africa, India, and the Middle East, that are most affected by volatility in currency and low oil prices. Of late, the airline had been expanding its operations in Brazil to provide connecting passengers to its partner Gol Linhas Aereas Inteligentes SA and in Asia through its hub at Tokyo’s Narita International Airport. However, now the airline has decided to trim up to 15-20% of its services in these markets to improve its pricing power and long-term margins. In addition to this, Delta will suspend all flights to Moscow during winters. We anticipate similar capacity adjustments by the other two large network carriers – American and United – to curtail the rising pricing pressure in the international markets. Both legacy carriers will release their first quarter results next week.

Capacity Discipline and Fuel Costs Savings to Drive Earnings in 2015 and beyond

For the second quarter, Delta expects its revenue to rise by 2% on a 3% increase in capacity. The airline estimates its unit revenue to be down by 2-4% due to continued currency fluctuations. However, the company plans to keep its non-fuel unit costs growth under 1% on a year-on-year basis. Delta also expects to realize savings of over $2 billion from the low fuel costs as its has significantly reduced its fuel hedging exposure for the last two quarters of 2015. Hence, we expect the airline’s profits to accelerate in the latter half of the year, if oil prices continue to remain at the current low levels. Consequently, the airline aims to achieve operating margin of 16-18% in the second quarter.

Delta’s full year system capacity will remain flat due to the capacity adjustments in the international markets. Given that the capacity adjustments will be completed by the fourth quarter of this year, we forecast Delta’s profitability to improve going into 2016, driven by improved unit revenues and more sustainable international margins.

Notes:
  1. Delta Announces March Quarter Results, 15th April 2015, www.delta.com []
  2. Delta Reports March Traffic Results, 2nd April 2015, www.delta.com []