Delta Air Lines (NYSE:DAL) held its annual investor day on Thursday. Investors seemed to like what they heard, sending the stock higher during the day. From a short-run perspective, it's easy to see why they were pleased. Delta raised its unit revenue and margin guidance for the fourth quarter, as November's solid demand trends have continued into December.
However, while Delta executives talked a lot about sustaining the company's strong margins in the coming years, they didn't offer many answers about how they will do that in the face of significant headwinds.
A nice guidance update
Earlier this month, Delta projected that it would generate a 9.5%-10.5% operating margin in Q4, incorporating the impact of its new pilot contract. Delta stated that excluding the pilot contract, this was equivalent to the high end of its previous guidance range. Improvements in the demand environment during November drove this favorable guidance revision.
Demand has continued to improve in the past two weeks, particularly for last-minute domestic bookings. As a result, Delta raised its guidance again on Thursday.
Delta now expects passenger revenue per available seat mile to decline about 3% this quarter, compared with its previous forecast of a 3%-5% decline. Meanwhile, the company raised its operating margin guidance range to 10.5%-11.0%.
Previous financial targets suspended
During the investor day conference, Delta executives spent a lot of time talking about the durability and sustainability of the company's financial performance. But management's credibility was undermined by the fact that the company simultaneously walked back the medium-term financial targets it had set earlier this year.
In May, Delta increased its financial goals. For the 2016-2018 period, Delta said it would target an operating margin of 17%-19%, annual per-share earnings growth of at least 15%, a 25% return on invested capital, $8 billion-$9 billion of operating cash flow annually, and $4.5 billion-$5.5 billion of annual free cash flow.
In 2016, Delta will achieve most of these goals, or at least come close. The major exception is free cash flow. Delta generated $3.2 billion of free cash flow through the first nine months of 2016, but it doesn't expect to throw off much more in the fourth quarter.
By contrast, in 2017, Delta is on pace to fall far short of most of these targets. CEO Ed Bastian said that the company's operating margin will probably decline by 1-2 percentage points next year, ending up around 15%. That means EPS and free cash flow will likely decline, too.
Can investors count on unit revenue growth?
Delta executives acknowledged that returning to unit revenue growth is vital for maintaining the company's margins. Due to the recent increase in oil prices, Delta expects fuel to represent a $1.2 billion cost headwind next year. Non-fuel unit costs are also projected to rise 2%-3%, adding up to $800 million of incremental costs.
Based on this outlook, Delta would probably need unit revenue growth of close to 5% just to keep its profit margin flat.
Yet Delta's management has admitted that it's not very good at predicting unit revenue. A year and a half ago, it projected that it could get unit revenue back to the flat line by the end of 2015. Instead, barring another setback, it will reach that milestone next month -- a year behind schedule.
Delta currently expects unit revenue to be roughly flat year over year in Q1. However, Bastian's rough margin guidance implies that unit revenue would rise about 3% for the full year.
This may be achievable, but it will be tough to get there. Transatlantic industry capacity continues to grow extremely quickly, putting pressure on unit revenue in Delta's most lucrative international region. Meanwhile, the opening of Tokyo's Haneda Airport for a limited number of daytime flights to the U.S. could decimate unit revenue for Delta's small competing hub at Narita Airport.
Conditions look better in the domestic and Latin American markets, but that may not be enough to overcome the headwinds in Europe and Asia. In any case, the key point is that Delta doesn't have that much control over its own unit revenue performance -- too much depends on macroeconomic factors and competitors' actions.
I'm not satisfied
Delta is doing a lot of things right. It has become the most reliable airline in the world through a focus on maintenance excellence. It also has better customer service than its peers. This has allowed it to post above-average margins and strong free cash flow.
That said, as a Delta investor, I was hoping to hear more detailed plans for how the company would either accelerate unit revenue growth to match rising unit costs or reduce unit cost growth to offset revenue weakness. Instead, Delta is on pace to fall short of its financial goals next year even though economic conditions are relatively favorable.
In light of Delta's lack of a firm plan to hit its financial targets in 2017 and beyond, I am reevaluating whether I want to maintain my investment in the company.