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Will Delta Air Lines, Inc.'s Widebody Fleet Renewal Boost Earnings?

By Adam Levine-Weinberg - Dec 21, 2016 at 11:10AM

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Delta is about to embark on a major overhaul of its long-haul fleet, bringing in 50 new Airbus A350s and Airbus A330neos. But turning these aircraft purchases into a meaningful earnings growth driver won't be straightforward.

In late 2014, Delta Air Lines ( DAL 6.00% ) ordered 50 next-generation widebody planes from Airbus ( EADSY 3.62% ) -- 25 A350-900s and 25 A330-900neos -- to overhaul its international fleet.

The first of those planes will arrive next year. Delta appears to have high hopes that this fleet renewal project will be a significant earnings growth driver. However, its ultimate impact will depend on the success of Delta's response to persistent overcapacity on international routes, particularly in the transatlantic market.

Delta replaces its 747s

When Delta announced the big Airbus order two years ago, it said that the A350s would replace its fleet of aging Boeing 747s on transpacific routes, delivering a 20% reduction in cost per seat.

Delta will retire the last of its 747s next year. Image source: Delta Air Lines.

At its investor day last week, Delta offered a much more modest target for cost savings. Based on 2016 fuel prices, the cost per seat of flying an A350 on a 5,500 mile flight would be about 3% lower than for a 747. Some of that discrepancy is related to a lower fuel price assumption. However, Delta was also probably planning to squeeze more seats onto each A350 when it made its original forecast.

On the other hand, Delta should see a big boost in unit revenue when it replaces a 747 with an Airbus A350. The A350 has 70 fewer seats, which means that Delta won't have to offer as many bargain fares to fill it up.

Delta's A350s will feature the carrier's new take on premium economy. Image source: Delta Air Lines.

Additionally, the A350 will have more premium seats, including 48 of Delta's new "Premium Select" extra-legroom seats. Lastly, while the 747 has traditional flat-bed business class seats in the "Delta One" section, the A350's 32 Delta One seats will feature a new all-suite layout that should be more appealing to business travelers and wealthy leisure travelers.

As a result, Delta Air Lines is likely to see a big margin improvement -- perhaps 20 percentage points -- for routes where it replaces a 747 with an A350. But there's one big caveat. Delta began 2016 with only nine 747s left in its fleet and it will end the year with just seven.

Today, 747s account for about 2% of the seats in Delta's fleet and operate just a handful of routes, mainly from Detroit and Honolulu to big cities in Asia. Those individual routes will become much more profitable, but the impact on Delta's companywide profit margin will be quite small.

The calculus behind replacing aging 767s

If there are only 7 747s left to replace, what does Delta plan to do with the other 18 Airbus A350s and the 25 Airbus A330neos it has ordered?

Some of the A350s may be used to launch new routes. Delta has currently paused its long-haul expansion in Seattle due to the airport's international arrivals facility being overcrowded. A new international arrivals facility with more than twice as much capacity is scheduled to open in late 2019. That could enable Delta to begin routes to far-flung places like Taipei and Singapore using A350s.

Most of the remaining A350s -- and all of the A330neos -- will be used to replace the oldest 767s in Delta's fleet. Delta currently operates 58 767-300ERs, with an average age of more than 20 years. Many of these planes will be ripe for replacement over the next five to seven years.

However, Delta's 767-300ERs are configured with 208-226 seats, whereas the A350 and A330-900neo will both have around 300 seats in Delta's configuration. That means adding a lot of capacity on any route where a new Airbus widebody takes over for a retiring 767.

Delta's new A330neos will be way bigger than the 767s they replace. Image source: Airbus.

This extra capacity helps the A330neo and A350 to offer 20% lower operating costs per seat than the 767-300ER. Yet Delta flies most of its 767s on transatlantic routes. The transatlantic market is currently flooded with excess capacity, driving down fares. Adding even more capacity there could drive unit revenue even lower, offsetting much of the unit cost savings.

How will Delta deal with this sticky situation?

It's not clear yet how Delta will mitigate the potential unit revenue pressure from upgauging all the way from a 767-300ER to an A330-900neo. One possibility is that it will squeeze even more seats onto its A330-900neos to further reduce its unit costs.

Alternatively, Delta could place more premium seats on the A330-900neo, as it is doing with its A350s. This could help to differentiate its product from rival carriers and might work well in big markets like London and Paris. However, for other routes, there might not be enough customers willing to shell out extra for Premium Select or Delta One seats.

Lastly, Delta could consolidate departures. This could either mean flying fewer times a day with larger planes on busy long-haul routes or flying to some overseas destinations from fewer of its U.S. hubs. That would allow Delta to use more efficient aircraft without adding capacity to the market. The risk is that Delta could alienate customers by having fewer flight options.

There's no clear "best" strategy for Delta. Any course of action has potential pitfalls. The choice of strategy could determine whether or not Delta's widebody fleet renewal becomes a material earnings growth driver for the company in the next five years.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Delta Air Lines, Inc. Stock Quote
Delta Air Lines, Inc.
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