In recent years, Delta Air Lines (NYSE:DAL) has routinely posted stronger earnings results than its top rivals, American Airlines (NASDAQ:AAL) and United Continental (NASDAQ:UAL). Entering the third quarter, Delta expected to continue its run of strong profitability.
However, fuel prices have started to rise again, and airfares aren't increasing fast enough to keep pace. A recent price war sparked by United Continental is probably contributing to the ongoing weakness in domestic fares. As a result, Delta Air Lines just significantly reduced its third-quarter margin forecast.
Delta's guidance comes down
Back in mid-July, Delta projected that it would earn a strong 18% to 20% operating margin (excluding special items) during the third quarter. That would have been roughly in line with its margin performance in the year-earlier period. Delta expected to offset its cost increases with a solid 2.5% to 4.5% uptick in passenger revenue per available seat mile (PRASM).
Delta now acknowledges that this guidance was too aggressive. First, fuel prices have been creeping up in the past couple of months. The carrier now expects to pay an average of $1.68/gallon to $1.73/gallon for jet fuel in the third quarter, compared to an original estimate of $1.55/gallon to $1.60/gallon.
Second, fares for last-minute domestic bookings haven't recovered as much as management had hoped. Thus, Delta Air Lines now expects to report a more modest 2% to 3% PRASM gain this quarter. The net result is that Delta has reduced the midpoint of its third-quarter margin guidance by 2 percentage points. Its new operating margin forecast for the quarter is 16.5% to 17.5%.
Will American and United feel the pain?
Delta's guidance cut doesn't bode well for American Airlines and United Continental. All three carriers are highly exposed to changes in the domestic fare environment (although United has a somewhat greater international footprint than its rivals). Furthermore, unlike Delta, American and United will bear the full cost of rising refining margins in the wake of Hurricane Harvey.
As of July, American and United both had lower third-quarter margin forecasts than Delta. American Airlines called for a 10% to 12% pre-tax margin, while United expected to report a 12.5% to 14.5% pre-tax margin for the quarter.
It's extremely likely that American and United will have to reduce their third-quarter margin forecasts at least as much as Delta. (United in particular will sustain a massive earnings hit due to the impact of Hurricane Harvey on its Houston hub.) Given that they were starting from lower projected levels of profitability, the proportional impact on their earnings will be even greater.
How will airlines react?
Jet fuel prices will likely recede to some extent this fall, after refineries fix the damage from Hurricane Harvey and return to full capacity. This might encourage airlines to stay the course, figuring that profitability will rebound soon enough.
On the other hand, fare weakness has been a recurring problem for airlines lately. Unit revenue finally seemed to be moving in the right direction earlier this year, but that has abruptly changed since United Continental became more aggressive about matching other carriers' fares.
All three legacy carriers posted steep margin declines in the first half of 2017. They are now set to report another quarter of weak margin performance -- especially American and United. Perhaps this will convince executives at those two companies to adopt a more refined competitive strategy. If not, airline profits may remain under pressure for the foreseeable future. The silver lining for Delta Air Lines is that as the most profitable legacy carrier, it is likely to weather an industry fare war better than either of its rivals.