Delta’s 2Q Results Beat Market Estimate On The Back Of Lower Fuel Costs

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Delta Air Lines (NYSE: DAL) opened the earnings season yesterday on a positive note, posting an adjusted profit of $1.27 per share [1] for the June quarter, comfortably exceeding the market’s estimate of $1.22 per share.  The Atlanta-based airline reported a Non-GAAP profit of over $1 billion due to the fuel cost savings, despite a decline in its passenger unit revenue during the latest quarter. While the airline projects its unit revenue to continue to fall due to rising competition in its international markets, we expect the cost savings from lower fuel prices to drive the airline’s margins in the next quarter.

We currently have a price estimate of $48 per share for Delta, approximately 9% ahead of its current market price. We will be updating our valuation model for the company shortly.

See our complete analysis for Delta Air Lines here

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Revenue Growth Remains Weak As Unit Revenue Continue To Drop

During the June quarter, Delta’s passenger traffic grew 2.7% on a capacity increase of 3.4% compared to last year [1]. Yet, the airline’s load factor (number of seats occupied per flight) fell by 70 basis points to 85.6% during the quarter, which implies that the airline had to fly more empty seats per flight due to the capacity expansions. Despite this, Delta managed to exceed the market’s revenue estimate of $10.6 billion by reporting a quarterly revenue of $10.7 billion, 0.8% higher on a year-on-year basis. However, on a closer look, we realize that the airline’s passenger revenue actually slipped by 1% during the quarter due to a sharp drop in its unit revenues. Delta’s passenger revenue per available seat mile (PRASM), a measure of unit revenue, fell 4.6% on an annual basis due to the currency headwinds, and lower international fuel surcharges, coupled with the rising competition in the international markets. However, the impact of weaker international operations was more than offset by the strong domestic markets and increase in the sales of non-jet fuel products to third parties by its oil refinery.

Lower Fuel Prices Boost Delta’s Bottom Line

Despite a sluggish revenue growth, Delta posted a solid growth in its net profit for the second quarter on the back of lower fuel prices paid during the quarter. The airline’s average fuel price stood at $2.40 per gallon, more than half a dollar lower as compared to the last year, resulting in fuel cost savings of almost $1 billion during the latest quarter. However, unlike its close competitors American Airlines and United, who will be reporting their 3Q results next week, Delta had a high exposure to fuel hedges which restricted the airline from enjoying the benefit of the lower crude oil prices during the quarter. As  a result, the airline’s fuel cost savings went down by almost half a billion due to the mark-to-market adjustments in the second quarter. Despite this, the airline managed to deliver an operating margin of 16.8%, in line with the company’s guidance for the quarter((Delta’s Investor Update, 2nd July 2015, www.delta.com)), due to a 1% decline in its adjusted unit costs from various cost reduction initiatives taken by the airline during the June quarter. This marks the eighth consecutive quarter where the airline has been successful in keeping its unit cost growth under 2%, in line with the airline’s long-term target.

Efficient Use Of Free Cash Flows  

Delta, the third largest US airline by traffic, generated an adjusted operating cash flow of $2.5 billion and $1.6 billion of free cash flow during the quarter((Delta’s Third Quarter Guidance, 15th July 2015, www.delta.com)). The airline used these strong cash flows to reinvest almost $1 billion in the purchase of new aircraft. Further, it returned $1 billion to its shareholders via dividends worth $72 million and share repurchases of $925 million. Lastly, the airline used the remaining money to write down its long-term debt, strengthening its balance sheet.

In addition, Delta is planning to buy a stake in Japan’s third largest airline, Skymark Airlines, to pull it out of its financial troubles. This deal will strengthen Delta presence in the Japanese domestic market, especially after losing the coveted Seattle-Haneda (Tokyo) landing slot to American Airlines last month.

Outlook for 3Q and beyond

For the next quarter, Delta plans to grow its total capacity at a rate of 3% on an annual basis((Delta’s Third Quarter Guidance, 15th July 2015, www.delta.com)). However, the airline forecasts its unit revenue to decline by 4.5%-6.5% on a year-on-year basis, as the stronger US dollar, and stiff international competition, will continue to pose a threat to the company’s unit revenue. On the cost side, Delta has significantly reduced its fuel-hedging exposure for the second half of 2015 and expects its fuel price to average around $1.90-$1.95 per gallon for the next quarter. For the second half of the year, the company projects its fuel prices to be in the range of $1.90-$2.00 per gallon, much lower compared to an average of $2.65 per gallon realized in the first six months of the fiscal. Consequently, the airline anticipates its third quarter operating margin to be in the range of 19%-21%, translating into an EPS growth of 30% on a year-on-year basis. Accordingly, the analysts expect Delta’s next quarter earnings to be $1.64 per share.

Earlier this year, Delta had announced its plans to pull back its international capacity in the last quarter particularly in markets such as Africa, India, the Middle East, Russia, Brazil, and Japan, that have been hit by the currency fluctuations and oil prices. Based on this guidance, we expect Delta’s total capacity to remain flat in the fourth quarter, and mitigate the pressure on the airline’s unit revenues going forward.

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Notes:
  1. Delta Announces June Quarter Profits, 15th July 2015, www.delta.com [] []