Last week, Delta Air Lines (DAL 2.46%) gave investors a lot of reasons to be confident in the company's unit revenue trajectory. Management highlighted the strength of Delta's brand -- particularly among millennials who travel frequently for work -- along with the benefits from the carrier's credit card partnership with American Express and its segmentation initiatives.
These factors are already driving tangible results. Delta Air Lines recently took the No. 1 spot in every category in the annual Business Travel News airline survey. Moreover, passenger unit revenue is set to rise 4% year over year this quarter.
However, Delta's cost performance hasn't been nearly as impressive. Delta Air Lines could deliver strong profit growth in 2018 and beyond, but only if it gets unit costs back in line.
Losing control of costs
For the past several years, Delta Air Lines has had an official goal of limiting its annual non-fuel unit cost growth to 2% or less. As recently as 2015, it was hitting that target.
However, non-fuel unit cost growth has gotten out of hand in the past two years. In 2016, Delta's non-fuel unit costs increased 3.7% year over year. A steep increase in pilot wages was the main driver of this uptick in costs. Delta also handed out more modest, but still significant, raises to most of its other employees. All of the company's unit cost growth was driven by these pay increases.
Delta implemented another round of wage increases for most of its non-pilot employees in 2017. It also slowed its growth rate to 1%, putting pressure on unit costs. Lastly, the company has invested in product improvements (such as reintroducing free meals on some transcontinental flights) and upgraded technology.
As a result, management projected a year ago that non-fuel unit costs would increase 2%-3% in 2017. However, unit cost inflation has been much worse than that estimate. Delta now expects non-fuel unit costs to increase by an unsightly 4.5%-5% for the full year.
Cost discipline is now the top priority
For the past few years, Delta's management team has put a lot of effort into revitalizing unit revenue growth. To some extent, this required investments that put pressure on unit costs. The focus on driving unit revenue growth may have also pulled management's attention away from cost-control initiatives.
With unit revenue now rising in each of Delta's four geographic segments, management will put much more effort into holding down unit costs in 2018 and beyond.
Some improvement in Delta's unit cost trajectory is already more or less locked in. First, the carrier is set to increase its capacity growth to 2%-3% next year, which will help reduce unit cost growth. Second, Delta is ramping up its fleet renewal project, which will cut maintenance costs and drive higher employee productivity. Third, Delta's unit costs were artificially inflated this year by unusually disruptive storms that impacted its hubs.
In addition, Delta revealed at the investor day that it is working on a major cost efficiency program. The company expects that this will generate $200 million of savings next year and annual savings of $1 billion by 2020.
A return to margin expansion
Delta Air Lines is currently on track to face a 2- to 3-percentage-point pre-tax margin headwind from higher fuel costs in 2018. However, Delta should be able to more than offset this cost pressure through unit revenue growth. The company's projected 4% passenger unit revenue increase for the fourth quarter indicates that it is on the right track from a revenue standpoint.
Thus, minimizing non-fuel unit cost growth will be the key to driving margin expansion in 2018 and thereafter. Management thinks that Delta could potentially achieve zero non-fuel unit cost growth next year. Investors should keep a close eye on Delta's progress toward this goal.