How Delta Air Lines and Lower Fuel Costs Could Equal Huge Returns

When reviewing the numbers of Delta Airlines (NYSE: DAL  ) , you might be shocked that it's, well, an airline. The domestic airline with the largest market cap is starting to act like a real corporate citizen: paying down debt, paying a dividend, and actually buying back company stock. And amazingly, it's achieved this success despite stubbornly high oil prices.

Just last year, Delta bought a refinery in an attempt to dramatically reduce the costs of jet fuel. What originally looked like a desperate, ill-conceived move has become almost an afterthought, with Delta and other airlines reporting strong profits despite the high price of fuel. Even bankrupt AMR (NASDAQOTH: AAMRQ) and its prospective partner US Airways (NYSE: LCC  ) are generating huge gains, despite fuel costs and a merger blocked by the Department of Justice.

Fuel impact
In the latest quarter, Delta spent an incredible $2.3 billion on aircraft fuel for the mainline airline only. Its regional fleet spent another $544 million on fuel.

For Delta, aircraft fuel is the largest operating expense, exceeding salaries by more than $300 million annually. Mainline fuel cost an incredible 30% of passenger revenue. To reduce that cost, the company generates more than $1 billion from cargo and other revenues. But even when you factor in those gains, then add in regional fuel costs, Delta's total fuel expenses amount to 27% of revenue -- a staggering number, especially considering that the price of fuel has dropped $0.17 per gallon since last year.

US Airways spent an incredible 35% of mainline passenger revenue on fuel -- an average of $3.01 per gallon, compared to only $2.97 at Delta. Yet US Airways nonetheless expanded its margins significantly, thanks to a 12.2% increase in mainline revenue and only a 2.4% increase in fuel costs.

AMR recorded similar margin improvements, leading to a substantial improvement in net income. The company rode a 7% mainline revenue increase and a small 1.8% fuel costs increase to a $527 million operating income improvement. Its total fuel costs of $2.2 billion accounted for nearly 33% of revenue. Fuel costs can only take partial credit for the operating income gains, as a 13.3% decrease in salaries contributed nearly $340 million of the improvement.

Financial impact

Brent crude continues to sit around $105, even with the shale boom in the US. A 20% decline would only send Brent crude down to $84, a level that has historically been high.

Last quarter, Delta spent roughly $2.84 billion on fuel and generated a $1.2 billion net profit. A 20% reduction to fuel would reduce the costs by over $560 million. Now, the real question is how much of that would drop to the bottom line due to the likelihood of fare cuts in the industry. The lower fares could increase ticket sales and offset the fare declines.

Either way, there's no doubt the airlines win with reduced fuel expenses. Even if only half of the fuel-cost reduction benefited Delta, it would add roughly $280 million to operating profits and increase total profits by around 20%.

While a 20% drop is a random and simple example, it should highlight to investors the possibility of substantial cost reductions, simply from a reduced commodity price.

Capital returns
It is absolutely incredible that an airline is not only returning substantial capital to investors, but also incredibly trading at less than 9 times earnings estimates. During Q3, Delta repurchased 4.8 million shares at an average price of $20.83, for a total of $100 million. It also paid $51 million in dividends, for a current dividend yield of 1.1%. The company even included $249 million in profit-sharing costs for the quarter.

Maybe most important to the sustainability of these capital returns is the decrease of net debt to below $10 billion. Delta ended 2009 with $17 billion in net debt, and it's averaging debt reduction of $2 billion per year. The new goal is to reduce net debt to $7 billion, or a level probably prudent to maintain considering low financing costs.

Bottom line
The reduction in fuel costs would be a huge boon to an industry already seeing some of the best years ever. Either the airlines will have to pass on the reduced fuel costs to travelers, which will boost ticket sales, or they'll be able to increase margins.

The industry might be the biggest beneficiary all around, with consumers more willing to travel based on lower fares, and more spending money because they won't have to pay so much for gas for their own cars, trucks, or other vehicles.

Delta will benefit substantially unless its refinery backfires, but the other airlines such as US Airways and American Airlines -- whether merged or separate -- could see major benefits from lower fuel costs. These airlines are already paying higher percentages of revenue, and the reduced prices could benefit them even more.


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