Delta Air Lines (NYSE:DAL) reported solid Q2 earnings last week, with adjusted EPS up more than 20% year over year despite a decline in unit revenue and a $600 million fuel hedging loss. Furthermore, the company's guidance suggested that some of the headwinds preventing even faster profit growth are dissipating.
Following the Q2 earnings report, Delta's management spent an hour talking to analysts and reporters about the quarter and the outlook for the next few quarters. Here are 5 key points Delta executives emphasized.
We do not believe margin expansion driven largely by declining fuel prices, is sustainable over the long term, and our plan assumes rising fuel prices over time. Because of this, RASM growth is a necessary component of our business strategy...
-- Delta CEO Richard Anderson
Delta came into the year planning to drive a huge jump in profitability by holding fare levels flat while growing ancillary revenue and cashing in on the big drop in fuel prices. However, several factors -- including the strong dollar and overcapacity in certain markets -- have undermined its passenger unit revenue, or PRASM. Last quarter, PRASM declined 4.6% year over year.
Despite this negative development, Delta is still delivering solid EPS growth. Yet Delta CEO Richard Anderson isn't satisfied. He argued on the earnings call that profit growth driven entirely by falling fuel prices -- i.e. what Delta has achieved year-to-date -- isn't sustainable.
As a result, Delta is planning conservatively for the coming years. Rather than assuming that it will continue to benefit from low fuel prices, the company is focused on returning to unit revenue growth so that it can offset any increases in the price of jet fuel.
Cutting capacity where necessary
... [R]estructuring our Pacific network is one of our biggest opportunities for margin improvement going forward, and the early results of these efforts are positive. As part of these efforts, we'll be reducing our winter capacity in the Pacific by 6% to 8%...
-- Delta President Ed Bastian
The most important way that Delta is working to bolster its unit revenue growth is by cutting capacity on underperforming routes. International routes have generally underperformed domestic routes as the strong dollar has diluted the value of tickets sold in foreign currencies.
As a result, Delta is slashing its international capacity by 3.5% year over year for the upcoming winter season. The biggest cuts will come in the Pacific region, particularly Japan.
In connection with this adjustment, Delta will retire six of its Boeing 747 jumbo-jets later this year. By flying smaller widebodies on those routes, Delta will limit seat capacity, pushing the average fare higher. These smaller planes will also be much cheaper to operate than a 747.
Driving ancillary revenue growth
Total merchandising revenues and fees grew by 11%, led by incremental First Class revenue growth of 17% and Comfort+ growth of nearly 30%.
-- Ed Bastian
While passenger unit revenue derived from regular ticket sales has been falling at Delta recently, ancillary revenue is still on the rise. Delta has made this a key priority. For example, it has been working to transform its First Class sections from a free upgrade given to frequent fliers to a paid-for product. Its strong First Class revenue growth from Q2 shows that it is succeeding.
Going forward, Delta will continue to invest in initiatives to drive ancillary revenue growth. Delta Chief Revenue Officer Glen Hauenstein told analysts on the call that Delta will drive ancillary revenue growth in 2016 and beyond by making it much easier for customers to purchase some of its upgrade offers.
Efficiency through domestic upgauging
... [S]ince 2010 in the domestic entity, we have increased capacity approximately 1.2% per year, but that's been on 13% total fewer departures and 9% total fewer aircraft over that time.
-- Delta CFO Paul Jacobson
While Delta has been struggling a bit on the revenue side in 2015, it has demonstrated great cost control. That goes beyond the benefit of lower fuel prices. In Q2, adjusted unit costs (excluding fuel, profit sharing, and special items) fell by about 1% year over year for the second straight quarter. Delta also expects adjusted unit costs to remain flat in Q3.
Much of the credit can go to Delta's domestic "upgauging" initiative. By using larger planes and fitting more seats on existing planes, Delta has been able to increase its capacity while operating fewer flights, creating big efficiency gains. This trend will continue, as Delta is scheduled to take delivery of 95 new large narrowbody planes between 2016 and 2018 for its domestic fleet.
Dialing up capital returns
We expect to return nearly $2.5 billion to shareholders this year consistent with our goal of returning at least 50% of free cash flow through dividends and buybacks.
-- Paul Jacobson
One area where Delta really sets itself apart from the competition is free cash flow. It has been much more disciplined about holding down capital spending than some of its peers, keeping old aircraft in service longer and scouring the used aircraft market for great deals.
This discipline is allowing Delta to lead the industry in returning capital to shareholders. Just last quarter, it returned $1 billion to shareholders through dividends and share buybacks, after returning about $500 million in Q1.
Delta CFO Paul Jacobson told investors on the earnings call that Delta plans to return nearly $2.5 billion to shareholders in 2015. But the company made it more than halfway to that goal in the first half of the year. With earnings still on the rise, Delta could return even more cash than planned to its shareholders.
Adam Levine-Weinberg owns shares of The Boeing Company and is long January 2017 $40 calls on Delta Air Lines, 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.