On a pre-tax basis, 2015, 2016, and 2017 have been the three most profitable years in the history of Delta Air Lines (NYSE:DAL). A combination of low fuel prices, steady economic growth, and business travelers' preference for Delta over American Airlines (NASDAQ:AAL) and United Continental (NASDAQ:UAL) drove these strong results.
Nevertheless, while Delta Air Lines stock currently sits near an all-time high, it has risen just 16% over the past three years. That's less than half of the S&P 500's gain.
Two relatively recent developments -- Delta's return to unit revenue growth and corporate tax reform -- could make 2018 the year that Delta Air Lines stock finally breaks out. However, for that to happen, Delta will need to show that it can overcome the headwind from rising fuel costs while keeping non-fuel spending in check.
Revenue momentum has returned
Throughout 2015 and 2016, Delta Air Lines -- and most of its airline industry peers -- faced severe unit revenue pressure. Passenger revenue per available seat mile (PRASM) declined 3.3% in 2015 and another 4.9% in 2016. Effectively more than half of Delta's savings from lower fuel costs got passed through to customers.
In 2017, it became far more urgent for airlines to get unit revenue growing, as jet fuel prices started to rise again and labor costs climbed. PRASM decreased 0.5% in the first quarter, but Delta's unit revenue performance improved over the course of the year. PRASM rose 2.5% in the second quarter and 1.9% in the third quarter and is projected to rise by about 4% in the fourth quarter.
This trajectory puts Delta in a good position for 2018. It's entering the year with strong revenue momentum, but the carrier will still face relatively easy year-over-year comparisons for most of 2018.
The outlook for American Airlines and United Continental is less sanguine. American posted a 4.5% increase in revenue per available seat mile during the first half of 2017 -- well ahead of Delta -- giving it tougher year-over-year comparisons entering 2018. Meanwhile, United will face fairly easy comparisons but entered the new year with unit revenue in a tailspin.
Tax reform is handing Delta a big windfall
Tax reform is a second factor that could boost Delta Air Lines stock this year. At its investor day last month, the company disclosed that a reduction in the statutory corporate tax rate from 35% to 20% would boost its estimated 2018 EPS by $1.00-$1.25. The statutory rate has been set at 21%, so Delta will get most of that projected savings.
In addition, the tax reform bill creates incentive for capital spending by allowing companies to fully write off capital expenditures for the next five years. That's great timing for Delta, which is in the early innings of a major fleet renewal project.
As a result, Delta probably won't owe any cash taxes until 2020, a year later than previously expected. Even then, its cash tax rate will probably be just 12%-15%. Delta should have more cash freed up to spend on dividends and share buybacks in the next few years.
Execution will be critical
By the end of 2017, the market price of Gulf Coast jet fuel was around $1.90 per gallon, up about $0.35 year over year. This increase will represent a 3- to 4-percentage-point pre-tax margin headwind for most airlines in 2018.
This situation is particularly dangerous for American Airlines and United Continental. Not only will they potentially have a harder time producing robust unit revenue growth in 2018, but they're also starting from a weaker position. Both American and United are on track to produce single-digit pre-tax margins in 2017, compared with around 13% for Delta Air Lines.
Thus, Delta Air Lines stock could benefit from a "flight to quality" in 2018 as investors spurn underperforming carriers in favor of higher-margin airlines. That said, Delta will need to show that it can hold its pre-tax margin steady to win investors' favor.
That means the company can't afford any of the periodic unit revenue reversals that have plagued it in recent years. Delta Air Lines also needs to make good on its commitment to reduce non-fuel unit cost growth to a maximum of 2% -- and preferably closer to 0%. 2018 could be a breakout year for Delta Air Lines stock, but the company will have to navigate some tricky obstacles to make that happen.