Delta’s Path Towards Positive Unit Revenues

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Delta Air Lines (NYSE:DAL), like its peers, faced a challenging year in terms of unit revenue growth. Unit revenues, or passenger revenue per average seat mile (PRASM), were under the pump throughout 2016 due to the strong dollar, low fuel prices, geopolitical turmoil, and increasing competition from low cost carriers. Given the recent ascension of oil prices, on the back of OPEC’s decision to cut production, it becomes imperative for the airline to be able to turn around its unit revenues. To this end, the carrier has decided to cap its capacity growth to 1% in 2017. If the carrier fails to regain positive unit revenues, it will see a major impact on its operating margins.

In the following note, we discuss Delta’s path towards positive PRASM.

Earlier in the year, Delta had stated that it hoped to turn its PRASM positive by mid to late 2016. However, faced by a technical glitch in the third quarter, which led to cancellations and delays of a number of flights, the carrier failed to reach the target. Other factors that came into play to hinder positive PRASMs were domestic softness, foreign exchange headwinds, low fuel prices and geopolitical shocks. Consequently, the third quarter was one of the worst quarters for Delta, with revenue down 6% y-o-y and unit revenues declining -7% y-o-y. That said, the company expects the fourth quarter PRASM to come in better than expected at -3% y-o-y (earlier guidance of -5% y-o-y). The revision in PRASM expectation is attributable to the improvement being seen in domestic yields in the last few months. Going forward to 2017, the company wants to restrict its system-wide growth to 1%, with domestic growing 2% y-o-y and international shrinking 1% y-o-y.

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Before we go into details, one major advantage that the company has as it works to turn its unit revenues positive is its brand and customer focus. By investing in customer experience through fleet improvements, product, and network expansion, the company is able to a charge a premium to the industry. This premium could go a long way in ensuring positive unit revenues, if Delta is able to sustain it in 2017. To this end, Delta will be introducing A350-900 in the Pacific region, consolidating its domestic and international operations in LAX, replacing regional aircraft with Airbus, streamlined check-in process, new Sky clubs in Seattle and Atlanta, and improved amenities.

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Domestic Routes

Domestic revenues per average seat mile (RASM) have seen solid improvement post Trump’s election as the President, with 50% of capacity seeing positive RASM. As Delta enters 2017, it expects positive unit revenues due to the strong demand being seen. This is further fortified by the recent IATA study, which expects demand for air travel to increase in the next few years at a CAGR of 3.7%. However, we may see some consequences of rising oil prices to spillover in the form of higher fares, which, in turn, will likely cause the demand to falter. To ensure that domestic margins do not get affected, the company intends to grow capacity domestically at a conservative rate of 2% y-o-y in 2017. Furthermore, following the path of its competitor, United, it will work on segmentation and fee bundling to support revenues, while working to maintain its dominance in Boston (where JetBlue has entered).

Latin America

The advent of operations in Latin America has been a sweet spot for most airlines, struggling with negative yields. Delta has been no different. Its operations in Mexico, Cuba, and Caribbean have helped it slightly offset the headwinds being seen in Atlantic and Pacific. Entering into 2017, the company wants to renew its focus on the improving economy of Brazil. As currency fluctuations subside in the region, Delta expects to see higher fares and increased demand. To capitalize on the newly opened routes of Mexico and Cuba, which are a major tourist attractions, the company will likely grow the capacity in this region by 1% y-o-y in 2017.

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Pacific

The Pacific region has been a weight on the company’s yields through the year, mainly due to the weakness in the emerging economies and turmoil seen in the area. To restore growth to the region, the company will focus on removing under-performing routes from its system by cutting capacity by 6% y-o-y in 2017. It will realign its focus on Korean and Chinese economies, which are expected to be the drivers of growth for air travel going forward, while adjusting its offerings in Tokyo post the agreement allowing unrestricted flight movement between Japan and North America. However, due to the overcapacity built up in the region, industry-wide, the company expects to continue to see negative PRASM in the Pacific region.

Atlantic

With Europe’s economy undergoing major changes, such as Brexit, resignation of the Italian prime minister, and the largest immigration crisis ever post the Second World War, Delta will continue to struggle in the area. Furthermore, as JetBlue and Southwest expand their networks to transatlantic routes, Delta is likely to face fierce competition in the area. As a result, the carrier will keep its capacity in the area flat, while working to fulfill the seasonal demand to the area.

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