On Tuesday morning, Delta Air Lines (NYSE:DAL) confirmed that it is on track to deliver unit revenue and earnings in line with its initial forecast for the third quarter, despite the negative impact of Hurricane Florence.
Nevertheless, with oil prices on the rise again, investors are getting nervous about Delta's plans to return to margin expansion by the end of 2018. In particular, while Delta Air Lines expects to report a solid increase in revenue per available seat mile (RASM) for the third quarter, it won't reach the high end of its original forecast range. As a result, Delta shares fell about 3% as of the early afternoon on Tuesday.
What management had expected
Back in July, Delta Air Lines projected that it would achieve a pre-tax margin between 12% and 14% in the third quarter, down from 15.6% a year earlier. Although the company expected RASM to rise 3.5% to 5.5% year over year -- while adjusted non-fuel unit costs would remain flat -- higher oil prices were to remain a stiff headwind. Delta's initial quarterly forecast called for adjusted fuel costs between $2.32 and $2.37 per gallon, compared to $1.68 per gallon a year earlier.
Despite the expected pressure on its pre-tax margin, Delta's adjusted EPS guidance called for an increase from the Q3 2017 figure of $1.57 to a range of $1.65 to $1.85. That reflected the big benefit from a lower federal corporate tax rate.
Delta updates its guidance
Delta's end-of-quarter investor update showed that RASM growth is on track to come in between 4% and 4.5%. This includes a roughly 50-basis-point negative impact from Hurricane Florence.
Excluding the hurricane impact, unit revenue growth was roughly in line with the 4.8% adjusted RASM increase that Delta achieved in the first half of 2018. However, it's worth noting that the carrier faced an even bigger hurricane-related unit revenue headwind in the third quarter of 2017. Thus, it appears that Delta Air Lines' underlying unit revenue trend is moderating ever so slightly.
Perhaps surprisingly, fuel prices are on track to come in $0.10 per gallon below management's original estimate. Some of this may relate to profits from Delta's oil refinery. A dip in oil prices over the summer -- which didn't reverse until last month -- also probably contributed to the lower-than-expected fuel bill.
Finally, Delta met its goal of holding its adjusted non-fuel unit costs flat last quarter. As a result, adjusted EPS is set to land squarely in the middle of Delta's guidance range: between $1.70 and $1.80.
Will unit revenue momentum hold up?
Less than a month ago, Delta Air Lines projected that its pre-tax margin would be roughly flat year over year in the fourth quarter, compared to pre-tax margin declines of about 2% in the first three quarters of the year.
It will be challenging to achieve this target in light of a recent spike in oil prices. Since Delta made this forecast on Sept. 5, the price of Brent crude has jumped by more than 10%. This translates to an approximately $0.20-per-gallon increase in fourth-quarter jet fuel prices, relative to what seemed likely a month ago. That would create 2 percentage points of incremental margin pressure, potentially leaving Delta no better off than it has been year to date.
In other words, Delta will need to continue posting strong RASM growth in late 2018 and the first half of 2019 just to offset rising fuel prices -- let alone return to margin expansion. However, the year-over-year unit revenue comparisons will be tougher going forward.
In the first half of 2017, Delta's RASM crept up just 1.3% year over year. By the fourth quarter of last year, RASM growth had accelerated to 4.4%. As Delta starts to lap these strong unit revenue results, it will be difficult to continue growing unit revenue at a mid-single-digit pace -- even with the benefit of higher bag fees.
Investors will need patience
Given that Delta Air Lines didn't reach the high end of its RASM guidance last quarter, investors should probably expect further deceleration in its RASM trend as comparisons get harder. But as long as unit revenue continues rising at a 3% clip or better, investors shouldn't worry too much.
Delta's third-quarter results showed that its plan to hold non-fuel unit costs roughly flat in the next few years is feasible, largely due to the benefits from modernizing its fleet. Even after the recent uptick in fuel prices, RASM growth of around 3% should be enough to keep Delta's EPS roughly stable next year.
Eventually, fuel prices will moderate -- or at least stop rising. When that happens, Delta Air Lines' profitability is likely to improve dramatically. Until then, investors just have to be patient.