For the last two years or so, Delta Air Lines (NYSE:DAL) has been surging toward the top of the airline industry in terms of unit revenue and profitability. While the whole airline industry has become vastly more profitable in that time frame, Delta has been leading the charge.
Last week, Delta reported stellar Q1 results and strong guidance for Q2, capping the company's resurgence with an exclamation point. Delta is on track to meet all of its long-term financial goals in 2014, and it is poised for further improvements next year. As a result, it has fully earned its 300% stock gain since late 2012.
Delta's rise to the top
Network improvements and new amenities for business travelers have helped Delta post strong unit revenue growth for the past few years. For example, on the network side, Delta has been taking a lot of market share away from United Continental (NASDAQ:UAL) by expanding in New York.
United Continental's Newark hub has traditionally won the lion's share of business traffic in New York. However, Delta vastly improved its position in New York through a 2012 slot swap with US Airways that made Delta the largest carrier at LaGuardia Airport. Delta has also bolstered its international service through initiatives like its recent joint venture with Virgin Atlantic, which has vaulted it ahead of United into second place for service to London (a key business market).
On the product side, Delta has rolled out Wi-Fi across its entire domestic mainline fleet and on many regional jets. It also recently became the first U.S. carrier to offer flatbed seats with direct aisle access on every long-haul wide-body flight.
More recently, Delta has demonstrated strong cost control, allowing it to turn unit revenue gains into higher earnings. In 2012, Delta's 7% unit revenue improvement was almost fully offset by a 6% rise in unit costs. By contrast, Delta's unit revenue grew just 3% last year, but unit costs fell 1%, creating significant margin leverage.
Last quarter, Delta maintained its momentum, with unit revenue up 3% and unit costs down 1% once again. Moreover, the company's forecast for a Q2 operating margin of 14%-16% implies another quarter of substantial margin growth ahead.
Exceeding its financial goals
Late last year, Delta laid out five long-term financial goals: (1) 10%-12% annual operating margins; (2) 10%-15% annual EPS growth; (3) a 15% return on invested capital; (4) annual operating cash flow of at least $5 billion, with half reinvested in the business; and (5) investment-grade balance sheet metrics.
Based on Delta's Q1 performance and Q2 guidance, the company appears to be well on the way to meeting or exceeding all of these goals in 2014. Furthermore, the company has a good chance to improve its margins yet again in 2015. Most importantly, Delta will see an increasing benefit later this year and in 2015 from its initiatives to replace inefficient 50-seat regional jets with larger regional jets and small mainline aircraft.
Investors will be rewarded
Delta's strong performance puts the company on track to produce more than $3 billion of free cash flow this year and a similar amount next year. The company is targeting adjusted net debt of $7 billion by the end of 2015, compared to $9.1 billion at the end of last quarter, which will use up a little more than $2 billion.
Still, that leaves billions of dollars of free cash flow just within the next two years that will be available for higher dividends and share repurchases. Delta plans to update investors on its capital return plans later this quarter, and it's virtually inevitable that this will entail a significant increase in Delta's dividends, buybacks, or both.
Longer term, Delta's competitive positioning looks good, particularly in comparison to United Continental, which has been struggling mightily for the last two years. This should allow Delta to maintain a high profit margin and strong free cash flow for the foreseeable future.
Adam Levine-Weinberg is short shares of 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.