On Tuesday, Delta Air Lines (NYSE:DAL) reported adjusted EPS of $0.10, which beat analyst estimates by a small margin and represented the company's first Q1 profit in over a decade. However, most of that was expected based on previous guidance the company had given. On the other hand, investors were anxiously awaiting the company's Q2 guidance, because Delta saw an unexpected drop in demand during March, leading to a modest 2% unit revenue gain that missed expectations. At the time, Delta's management blamed the revenue slowdown primarily on the effects of the government sequester, as well as the weakening of the yen.
On the company's Tuesday morning earnings call, Delta confirmed that revenue weakness was continuing into Q2. In fact, according to Delta President Ed Bastian, unit revenue will decline by 2%-3% in April, before returning to modest year-over-year growth in May and June. The net effect will be roughly flat unit revenue for Q2. This breakdown in revenue gains should be of concern for investors, but it does not necessarily invalidate the bull case for Delta. Declining fuel costs are expected to more than offset revenue weakness, allowing Delta to continue posting year-over-year margin and profit growth.
The bull case
There are a few reasons why bulls can continue to support Delta. At the most basic level, Delta is the strongest of the global airlines today, as United Continental (NYSE:UAL) is in the midst of a merger that has impeded service quality and driven customers away, while American Airlines and US Airways (UNKNOWN:LCC.DL) are about to go through a similarly complex merger process. Meanwhile, Delta has been consistently profitable, which should give investors confidence in management's strategy and the company's ability to withstand a downturn.
Delta is also expecting a very strong operating margin of 9%-11% next quarter, despite the sluggish revenue environment. CEO Richard Anderson pointed out on Tuesday that there is a strong relationship between fuel prices and unit revenue today. The same factors that are hurting Delta's unit revenue are also pushing down fuel prices, which gives Delta offsetting cost savings. The management team is confident that the benefit of lower fuel prices will outweigh the lost revenue.
Lastly, Delta is in the middle of several initiatives to reduce "structural costs". The company is paring back on its staffing, reducing maintenance costs by using parts from retired aircraft, and swapping out inefficient 50-seat regional jets for larger planes. As these initiatives take hold through the rest of 2013 and beyond, it will keep cost growth to a minimal level, allowing future revenue growth to flow to the bottom line.
Bearish thoughts linger
For all of Delta's positive attributes, there are still significant risks for investors. First, Delta bought a refinery last year to lower its fuel costs, but it has not managed to turn a profit yet. While the refinery seems to have gotten past its start-up issues, investors do need to keep a close eye on that part of the business to make sure it is contributing to Delta's profitability.
Second, ongoing FAA furloughs have snarled air traffic at several points in the past few days, despite generally good weather in the U.S. As we enter the summer peak season, airlines could see massive delays and cancellations, particularly during weather events. Delays and cancellations on this scale could cause a drop-off in air traffic while imposing additional costs on airlines, including Delta. US Airways CEO Doug Parker stated on Tuesday that while it is possible to "manage" through the cuts in the short-term, it is not a sustainable situation; Parker also opined that things would get worse before they get better. If government gridlock on the issue continues, it will undoubtedly hurt Delta's peak season profitability.
Delta shareholders have earned tremendous profits in the last six months, but the future outlook is much less certain. Delta still has some significant opportunities to improve profitability going forward, but it also faces risks: most notably, the sluggish revenue environment and the ongoing FAA furloughs. Investors should carefully weigh the risks against the opportunities when deciding whether or not to invest in Delta.
Adam Levine-Weinberg is short shares of United Continental Holdings and is long Sep 2013 $33 Puts on United Continental Holdings. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.