Delta Air Lines (DAL -1.80%) returned to profit growth last quarter, following several quarters of margin contraction and falling earnings. However, despite the company's target of growing EPS at least 15% annually for the next few years, Delta Air Lines stock still trades for about 10 times earnings. This indicates that many investors doubt Delta can achieve its targets.
Obviously, Delta Air Lines' management feels otherwise. On the company's recent earnings call, several top Delta executives talked about why they are so optimistic. Here are five key points that they highlighted.
A revenue recovery is well underway
Our unit revenues are improving and tracking in line with the plan we laid out at our December investor day. The same is true for our non-fuel cost. However, fuel prices are lower, and this gives us increasing confidence in our ability to drive margin expansion in the back half of the year.
-- Delta Air Lines CEO Ed Bastian
Back in December, Bastian warned investors that the company would fall short of its long-term financial targets in 2017, as fuel and labor cost increases were outpacing revenue growth. Most notably, Bastian predicted that Delta's operating margin would fall by up to 2 percentage points year over year in 2017, ending up around 15%.
Delta entered this year with a relatively downbeat forecast. Image source: Delta Air Lines.
Fortunately, the outlook has improved over the past seven months. Unit revenue growth has accelerated as expected, while oil prices have declined modestly since December. As a result, Delta's management now believes that a 16% full-year operating margin is achievable.
Transatlantic business demand is surpassing expectations
... I'm pretty enthusiastic about how the first half of the year has shaped up relative to the capacity levels that are in the transatlantic. And what we've seen is really a higher demand in the business cabin on a year-over-year basis.
-- Delta Air Lines President Glen Hauenstein
For the past year or so, Delta's management has warned investors about overcapacity in the transatlantic market, which accounts for more than half of the carrier's international revenue. Indeed, transatlantic unit revenue slipped 1.9% year over year last quarter. Still, unit revenue trends in that region have improved dramatically in 2017 relative to 2016.
According to Hauenstein, strong demand from business travelers for premium seats has offset the impact of overcapacity on economy fares. Furthermore, business activity in Europe is improving and the euro's value is near a multiyear high. This bodes well for Delta's results in this key region during the second half of the year.
Delta's AmEx partnership is flourishing
Our partnership with American Express produced $70 million of incremental value this quarter and we are on pace to deliver $300 million of incremental value in 2017, including another record year for card acquisitions.
-- Hauenstein
Delta Air Lines' co-branded credit card partnership with American Express (AXP 0.02%) also represents a key source of long-term earnings growth. In addition to issuing the official Delta credit card, American Express also allows its customers to convert their Membership Rewards points to Delta SkyMiles. The two companies cooperate in other areas, too.
Delta is now American Express' most important co-brand partner, accounting for 7% of annual spending on its cards and about 20% of its outstanding credit card loans. Not surprisingly, American Express puts a lot of marketing muscle behind these Delta co-branded cards.
The result is that card-member acquisitions are rising. By 2021, Delta expects to generate $4 billion of high-margin revenue annually from its AmEx partnership, up from $2.7 billion in 2016.
Fleet renewal will support margin expansion
In 2017, we will continue to add more A321s and 737-900s to replace older narrowbodies and take out additional 50-seat regional jets. With larger aircraft, we can offer more premium products, supporting our revenue strategy, while being more cost-efficient.
-- Hauenstein
Fleet modernization is another key lever for Delta as the company works to expand its profit margin. Delta has replaced nearly 25% of its fleet over the past five years, and it will replace another 25% of its fleet by 2020.
Delta Air Lines is rapidly replacing its oldest planes. Image source: Delta Air Lines.
New aircraft are more fuel efficient and cheaper to maintain than older planes. Delta is also using this fleet renewal initiative as an opportunity to "upgauge" to larger planes, which tend to have lower unit costs than smaller ones. Meanwhile, many of these planes will offer more premium seats, allowing Delta to bolster its unit revenue and generate a higher profit margin.
Cost growth is abating
We expect unit cost growth in the September quarter to be up roughly 2% on a normalized basis, which puts us on the right trajectory to achieve our full-year 2% to 3% non-fuel CASM growth.
-- Delta Air Lines CFO Paul Jacobson
During the first half of the year, rising non-fuel costs crimped Delta's profit potential. On a normalized basis, non-fuel unit costs increased 3.6% year over year in Q1 and 5.5% year over year in Q2. By contrast, Delta expects its normalized non-fuel unit costs to rise just 2% this quarter and even less in the fourth quarter.
As unit cost increases flatten out, Delta's revenue momentum should really start to pay off in the form of margin expansion. Perhaps investors shouldn't be so skeptical of Delta Air Lines' ability to hit its financial performance targets in the years ahead.
