Last month, Delta Air Lines (NYSE:DAL) slashed its second-quarter guidance. In April, the company had forecast that it would achieve a 14% to 16% pre-tax margin and earnings per share of $1.80 to $2.00 in Q2. Its updated guidance called for a pre-tax margin of 13% to 14% and EPS of $1.65 to $1.75. Earlier this week, Delta reaffirmed this new forecast.
Rising fuel prices were the main cause of the guidance reduction. Delta increased its second-quarter jet fuel cost estimate by $0.13 per gallon during the quarter. With jet fuel prices remaining at elevated levels, investors expect the company to miss its full-year EPS guidance by a mile.
Fortunately, demand trends remain strong, limiting the damage from rising costs. Moreover, Delta's ongoing fleet renewal project will deliver substantial cost savings and fuel-efficiency improvements over the next few years, boosting its earnings power.
Cost creep has been Delta's problem
Revenue growth and cost containment are both important components of profit growth for any company. Delta isn't having any trouble on the revenue side of the equation. Unit revenue rose 5% in the first quarter and increased approximately 4% to 5% in the second quarter.
Nevertheless, Delta has experienced meaningful margin erosion since the beginning of 2017, due to a combination of non-fuel cost increases and a rapid rise in oil prices.
Fuel prices -- the biggest contributor to Delta's recent cost increases -- are clearly outside of the company's control. However, Delta Air Lines has opportunities to mitigate the impact of rising fuel costs by improving its fleet's fuel efficiency and minimizing non-fuel unit cost growth. Delta's ongoing fleet renewal project is critical to its efforts on both of those fronts.
New planes are coming -- and fast
In recent years, Delta has had one of the oldest aircraft fleets in the U.S., due to former CEO Richard Anderson's focus on holding down capital spending and maximizing return on invested capital. The carrier frequently opted for used aircraft to replace its older planes, rather than spending more to acquire new aircraft.
Delta Air Lines has changed course under new CEO Ed Bastian. Part of the strategy shift has been driven by rising maintenance costs for Delta's aging MD-88s and MD-90s. As of the end of 2017, Delta had 109 MD-88s and 65 MD-90s. The average age of the MD-88s was 27.5 years, while the average age of the MD-90s was 20.9 years.
Between 2018 and 2020, Delta expects to take delivery of 216 new mainline jets -- enough to replace about a quarter of its mainline fleet. This will allow the carrier to retire all (or nearly all) of its MD-88s and MD-90s, along with some of its other older planes.
Fuel efficiency will improve
Delta's fleet-renewal effort will help the carrier reduce its fuel consumption. The A321 uses about 30% less fuel per seat than the MD-88. For the A321neo -- of which Delta has ordered 100 for delivery between 2020 and 2023 -- the reduction in fuel burn per seat is 40% over the MD-88.
The planned fleet upgrades for the 2018 to 2020 period should improve Delta Air Lines' fuel efficiency by about 5%. The fuel burn improvements will continue during the following three years, as Delta takes the rest of its A321neos and replaces more of the wide-body aircraft it uses on international routes.
Based on the current price of jet fuel, Delta will spend a little more than 20% of its revenue on fuel. This means that a 5% reduction in fuel consumption would boost Delta's pre-tax margin by about 1 percentage point.
Non-fuel unit costs should improve, too
Delta Air Lines will also achieve substantial non-fuel cost savings by replacing its MD-88s and MD-90s with brand-new aircraft. Over the past year or so, the company has been incurring accelerated depreciation expense due to its decision to accelerate the retirement of these fleets. Those costs will go away as the airplanes are retired.
Additionally, as noted above, it is becoming increasingly expensive to maintain the MD-88 and MD-90 fleets. By contrast, the new planes that are entering Delta's fleet will be very cheap to maintain, especially early in their lives.
Finally, while some MD-88s will be replaced with smaller CS100 jets, the vast majority of the MD-88s and MD-90s will be replaced with large narrow-bodies (like the A321) as part of Delta's upgauging strategy. Larger aircraft tend to have lower unit costs.
Delta Air Lines retired about 10% of its MD-88/MD-90 fleet in the first half of 2018. Its pace of aircraft replacements will accelerate after the summer peak season. In the short run, Delta's pre-tax margin may continue declining anyway, due to runaway fuel-cost increases. However, once the price of jet fuel starts to stabilize, the cost savings from Delta's fleet renewal project should start to drive margin expansion and strong earnings growth.