Delta Air Lines, Inc.: Let the Good Times Roll!

Profit has exploded at Delta Air Lines, Inc. in the last couple of years, and the good times are set to continue.

Adam Levine-Weinberg
Adam Levine-Weinberg
Jul 24, 2014 at 12:42PM

Delta Air Lines, (NYSE:DAL) has gathered all the momentum of a jumbo jet in the last two years. Delta's earnings have soared, the company has cleaned up its balance sheet, and it has initiated a dividend and a stock repurchase plan. As a result, Delta's stock price has quadrupled compared to the summer of 2012.

DAL Chart

Delta Air Lines Price vs. Earnings Chart, data by YCharts

On Wednesday, Delta delivered yet another strong earnings report and equally strong guidance. Delta has already grown its earnings far past what most people would have thought was possible just a couple of years ago.

Delta may face an increase in competition from Southwest Airlines (NYSE:LUV) and other domestic-oriented airlines in the next few years. However, even if Delta's revenue gains slow down, the company is still in great position to keep growing earnings due to its cost control initiatives.

Margins keep growing
Last quarter, Delta's adjusted pre-tax income jumped by $593 million year-over-year to $1.4 billion. This represented a 15.1% operating margin, compared to the company's 11% operating margin in Q2 2013.

Delta's phenomenal margin growth has been powered by three different factors: strong unit revenue growth, non-fuel cost discipline, and fuel cost reductions.

Delta has posted phenomenal earnings growth recently (Photo: The Motley Fool)

On the first front, a combination of strong travel demand and industry capacity discipline helped Delta achieve a 5.7% unit revenue gain in Q2. Delta has benefited enormously so far from the Southwest-AirTran merger. Southwest Airlines is rapidly winding down the AirTran brand, and as part of that process it has cut a lot of capacity in Atlanta -- the main hub for both Delta and AirTran.

In the second area, Delta's move to retire costly 50-seat regional jets in favor of mainline aircrafts is having a major impact on unit costs. As recently as Q1 2013, non-fuel unit costs increased 5% year over year at Delta. By contrast, non-fuel unit cost growth has been less than 2% for each of the last four quarters, and non-fuel unit costs will rise less than 1% for the full year.

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In the last area, while Delta's oil refinery hasn't produced much profit yet, the company is benefiting from ongoing fuel efficiency initiatives as well as traditional fuel hedges. In fact, Delta spent less money on fuel last quarter than in Q2 2013, despite a 3.2% increase in capacity.

Cost control will be key moving forward
Delta is forecasting slower unit revenue growth of 2%-4% next quarter. Indeed, unit revenue growth may be harder to come by going forward. First, comparisons will be tougher. Second, while Southwest Airlines has kept capacity flat this year, it plans to start growing again in 2015.

Domestic giant Southwest Airlines plans to increase its growth rate next year (Photo: The Motley Fool)

Other low-cost and ultra-low-cost carriers are also planning to grow faster next year due to the strong revenue environment. This will naturally put pressure on domestic unit revenue -- and the domestic region has generated the biggest gains recently.

However, Delta does expect to keep non-fuel unit cost growth below the 2% line for the next few years, which will allow the company to better handle a slow unit revenue growth environment.

Most importantly, Delta has a long way to go in its fuel efficiency initiatives. As noted earlier, replacing 50-seat regional jets with mainline-size planes reduces non-fuel costs, but it also has a huge impact on fuel consumption. The 717s Delta is adding to its fleet consume about 30% less fuel per seat than the 50-seat jets they are replacing.

Delta is also steadily renewing its fleet by replacing its oldest planes with newer, more fuel-efficient models. Lastly, Delta is boosting fuel efficiency for some of its older planes by adding seats. For example, Delta will boost seating capacity by almost 10% on 56 Boeing 757s.

These initiatives are already having a noticeable impact. Fuel efficiency has improved slightly more than 1% this year. The gains should accelerate soon as Delta starts to retire more 50-seat jets and makes progress on cabin modifications to increase seat density.

Bottom line
Delta has made huge earnings gains in the last two years as it has taken advantage of the strong fare environment to boost revenue, while simultaneously reining in cost inflation. Delta's cost containment initiatives are just hitting their stride. Assuming oil prices remain stable, Delta should be able to keep its unit costs approximately flat for the next few years.

That's great news for investors. Unit revenue gains will probably be harder to come by in the coming years as comparisons get tougher and domestic-focused airlines start expanding more rapidly. Delta is well-positioned to maintain a solid earnings growth rate anyway.