After two years of nearly flawless execution -- which sent its stock price from single-digit territory to the $50 level -- Delta Air Lines (DAL -1.71%) has stumbled in 2015. Aggressive fuel hedging has prevented it from reaping the full benefit of lower oil prices, while the low-fuel-price environment has contributed to unit revenue pressure.
While these issues continued to impact Delta in Q2, the company still reported double-digit earnings growth. More importantly, the worst appears to be over, setting the stage for stronger stock performance going forward.
Delta's quarter by the numbers
In Q2, Delta's revenue rose 0.8%, to $10.71 billion, slightly exceeding the average analyst estimate of $10.65 billion. Delta's adjusted EPS hit $1.27, up from $1.04 in the prior-year quarter. That beat the consensus estimate of $1.21 -- but still fell well short of the $1.36 in EPS that analysts had expected at the beginning of the quarter.
Delta's revenue and EPS gains came in spite of a 4.6% decline in passenger-unit revenue, or PRASM. PRASM declined in all regions of the world, but the drop was far more severe on international routes than in the domestic market.
Domestic mainline PRASM fell 1.1% year over year, while regional PRASM fell 1.4%. By contrast, PRASM fell 11.5% in the Atlantic region, 8.5% in the Pacific region, and 7.8% in Latin America, due to a combination of the strong dollar, lower fuel surcharges, and spotty economic growth.
Delta managed to post solid EPS growth despite this unit revenue weakness due to a double-digit reduction in its unit costs. This consisted of a nearly 1% decline in adjusted CASM -- which excludes volatile items like fuel, profit-sharing, and special items -- an 18% decline in the average fuel price paid, and fewer special items.
Delta vs. the competition
While Delta's 4.6% PRASM decline last quarter was nothing to write home about, it was actually better than what its two main competitors -- American Airlines (AAL 0.66%) and United Continental (UAL -0.72%) -- are expected to report. American Airlines has projected that PRASM fell 6%-8% last quarter, while United Continental expects a decline of 5.25%-5.75%.
However, there's one key difference between Delta's situation and those of American and United. While Delta had aggressively hedged its Q2 fuel costs, American Airlines does not hedge at all, and United Continental has been reducing its hedge exposure. As a result, American and United paid significantly less for fuel last quarter than Delta's all-in cost of $2.40/gallon.
The outlook for Q3 and beyond
In the short run, Delta doesn't expect its unit revenue declines to subside. The company expects PRASM to fall 4.5%-6.5% year over year in Q3, as all of the pressures it faced in the first half of 2015 remain in place.
However, Delta has much lower fuel-hedging exposure in the second half of 2015. Delta expects to pay just $1.90-$1.95/gallon for fuel in Q3, and $1.90-$2.00/gallon for the full second half of the year, compared to an average of $2.65 in the first half of 2015.
This will allow it to post better than 30% year-over-year EPS growth this quarter, according to CEO Richard Anderson. Based on Delta's guidance for a Q3 operating margin of 19%-21%, the average analyst EPS estimate of $1.64 appears to be right on target.
The outlook for Q4 is even brighter. Delta announced in April that it will implement deep capacity cuts in underperforming markets -- including Africa, India, the Middle East, Russia, Brazil, and Japan -- during the off-peak season. As a result, total system capacity will be roughly flat in Q4, with international capacity down.
That would be in stark contrast to last quarter, when capacity was up 3.4% year over year, with capacity growth of 5% or more in the Atlantic and Latin America regions. Delta's efforts to bring supply back in line with demand should drive much better unit revenue performance in Q4 and throughout 2016.
While Delta shares originally rallied after the earnings announcement, the stock was down nearly 3% by 9:15 a.m. in pre-market trade. However, with Delta stock trading for just 10 times projected 2015 earnings and eight times projected 2016 earnings, solid execution should be enough to drive the stock higher in the next year or so.