Delta: Now joining the "high quality industrial transports" Jan/Feb 2014
In the past year Delta Air Lines has beaten its US legacy carrier peers handsomely on all financial fronts, be it profit margins, ROIC, debt reduction or returning cash to shareholders. But that was just the start. The airline indicated at its investor day in December that it is focused on “taking performance to the next level”, as it strives to become like any other “high-quality S&P 500 enterprise with consistent earnings, double-digit returns on capital and strong free cash flow”.~
Delta was fortunate in that it had a multi-year head-start over its peers on the merger front. It completed a successful merger with Northwest in May 2008 and accomplished a quick and smooth integration. Since then it has enjoyed a long period of relative calm, during which the management has been to focus fully on managing the airline to the best of their abilities. In contrast, UAL and AAL both still face major challenges and risks associated with merger integration (see Aviation Strategy, November and December 2013 issues).
So Delta was able to quickly reap the benefits of the merger and start generating healthy cash flow and profits. 2013 was its fourth consecutive year of $1bn-plus pretax earnings. Delta earned a record $2.7bn ex-item net profit last year, more than twice as much as any other US airline. Its adjusted operating margin was 10% and ROIC 15%.
Probably the key reason for the post-merger Delta’s success is that it has exhibited remarkable capital spending restraint, despite having a relatively old fleet. There have been some new aircraft orders — most recently, in September 2013 Delta ordered 10 A330s and 30 A321s for delivery in 2015-2017 — and, of course, many interesting strategic investments (an oil refinery and equity stakes in three foreign airlines). But Delta has used the bulk of its free cash flow (FCF) to reduce debt. It has led the industry on that front, having reduced its adjusted net debt from $17bn at the end of 2009 to $9.4bn at year-end 2013.
In May 2013 Delta became the first of the big networks to announce a programme to return capital to shareholders. So far the programme has included $500m of share buybacks (due to be completed by this June, two years ahead of schedule) and the carrier’s first quarterly dividend payments in a decade in November (totalling $200m in the first year).
New financial goals
As explained at the investor day, Delta’s management has benchmarked the airline against “high quality industrial transports” — companies that are part of S&P 500 and Dow Transportation indices such as FedEx, UPS, Union Pacific, CH Robinson, CSX Corp and Kansas City Southern — and formulated new financial targets.
First of all, Delta is aiming for annual EPS growth of 10-15% and a ROIC of 15%. Those targets are slightly higher than the five-year averages for the industrial transports sample (10% EPS growth and 14% ROIC). Delta’s long-term annual operating margin goal is 10-12%.
Second, Delta aims to generate at least $5bn of annual operating cash flow. Last year it generated $4.8bn, though that represented a significant increase from the annual average of $2.5bn seen in 2009-2012.
Third, Delta’s five-year plan calls for capital spending of $2-2.5bn per year, down from $2.7bn in 2013. There will be a “rigorous” decision process for capital projects, with senior leadership involved in all decisions of $1m or higher to ensure that projects meet a minimum 15% return target with less than two-year pay back. The current projection for 2014 capex is $2.3bn — a level significantly lower than UAL’s or AAL’s.
Fourth, Delta wants to deleverage more. Having achieved its previous $10bn adjusted net debt target in mid-2013, the management has set a new lower target of $7bn, which it expects to reach sometime in 2015.
Fifth, Delta is now striving for investment grade credit ratings — something that only Southwest among the US carriers has attained.
The debt reduction strategy led to a material $153m reduction in Delta’s interest costs in 2013. It was also a key reason behind S&P’s decision to raise Delta’s corporate credit rating from B+ to BB- in December — something that will facilitate lower-cost financings or refinancings. That said, based on Delta’s current metrics (for example, a debt/EBITDA ratio of 4.4x at year-end, projected to fall to 3.7x-4.2x in 2015), even if all goes well, it is likely to take several years to reach the coveted BBB-/Baa3 investment grade ratings.
Sixth, Delta is determined to address its pension obligations. In 2013-2014 it is contributing an incremental $500m to its defined-benefit pension plans (which, unlike at some competitors, were not terminated in Chapter 11). That would be in addition to the $650-700m annual required contribution. The additional funding, combined with higher discount rates, reduced Delta’s unfunded pension liability last year by over $3bn to $10bn.
Seventh, shareholder returns feature prominently in Delta’s plans. The executives noted at the investor day that returning cash to shareholders is a key attribute of high quality companies. Delta expects to announce its next repurchase authorisation and a new divided policy by its late-June annual meeting.
Delta executives describe the overall approach as “balanced capital deployment”. It means continuing to invest in the business when the returns justify it, paying down debt, and using the remainder of FCF to reward shareholders and reduce pension liability.
Delta expects to “significantly” improve its operating and pretax results in 2014. Having brought costs under control last year with the help of a new $1bn structural cost cutting programme, the airline expects to keep ex-fuel CASM increases below 2%, or below inflation, in 2014 and beyond. Employee relations are among the best in the industry (the 2013 results included~$506m in profit sharing payments, or 8% of employees’ pay). And there are many new revenue initiatives under way.
Analysts like the cash flow, profit and ROIC targets and consider them realistic. After all, Delta is already (more or less) achieving many of the targets. Delta is regarded as a much safer bet than UAL or AAL.~ Remarkably, even though the stock surged by 131% in 2013 and by another 13.3% in the first six weeks of 2014, it is still recommended as a “buy”. As of February 13, the stock had a mean target of $39.69 among 16 analysts, meaning that it is expected to appreciate by more than 27% over the next 12 months.
Of course, achieving the targets will depend on the successful execution of a number of key cost and revenue initiatives. The main ones are domestic re-fleeting, various product and facility improvements, commercial cooperation with JV and other partners, gaining corporate market share in New York, making Trainer refinery profitable, and growing the network at key locations.
As one of the key measures to keep CASM increases in check, Delta is in the middle of an extended domestic fleet restructuring. The programme kicked off with the closure of regional subsidiary Comair in 2012 and will mean a dramatic reduction in small RJs in favour of operating more mainline aircraft and larger RJs. By 2015 Delta’s fleet will have only 100-125 50-seat RJs, down from nearly 500 in 2008. The average gauge (seats per aircraft) in domestic operations will increase from 119 to 138 in the same period.
Delta is bringing in both new and used aircraft. It is deploying 737-900s, 717s (ex-AirTran, which Southwest did not want) and large two-class RJs (such as CRJ900s) to replace 50-seaters. The new fleet~improves both cost efficiency and customer experience. Delta has seen solid margin improvements in markets where the larger aircraft have been deployed.
Product and facility investments
Delta has invested heavily in aircraft interiors and the product generally, because such investments extend the life of its existing fleet and allow it to avoid new aircraft purchases. Since 2010 there has been what the airline calls a “multi-year focus on passenger comfort”, with more than $3bn spent to improve the customer experience onboard and at airports.
First, like the other US global carriers, Delta focused on its international product. The key project has been the installation of full flatbed seats in international premium cabins — a process that will be complete by mid-2014.
Second, Delta has focused on the transcontinental market, where competition intensified last year when JetBlue brought out a premium offering. To start with, Delta added flatbeds to the premium cabins of its 757s and 767s on the key transcon routes and offered more dining and entertainment options. All transcon flights will have full flatbeds in premium cabins by summer 2015.
Third, Delta has spent heavily on customer offerings at LaGuardia, JFK and Atlanta airports as part of new international terminal openings (JFK and ATL) or major expansion and renovation projects (LGA). The New York airport investments are part of a “Win in New York” strategy (discussed below).
Fourth, Delta announced plans recently to spend $770m over the next three years to refurbish and upgrade the interiors of 225 domestic narrowbody aircraft, including 757-200s, 737-800s, A319s and A320s. All domestic two-class aircraft offer access to Wi-Fi (as will the entire international fleet by 2015).
Investments in airline partners
In addition to the continued development of the JV with Air France-KLM and Alitalia, which is probably the most deeply integrated of the transatlantic JVs, in the past two and a half years Delta has acquired minority equity stakes in three foreign carriers, as part of long-term “exclusive” commercial alliances”. First, there was a $65m investment for a 4.2% stake in Aeromexico and a seat on its board (August 2011). In December 2011 Delta invested $100m for a 3% stake in Gol; the deal also gave it a board seat, two 767s and an exclusive codesharing agreement in the US-Brazil market. And in June 2013 Delta completed its acquisition of a 49% stake in Virgin Atlantic; the airlines’ immunised JV became effective on January 1.
The Aeromexico deal has extended Delta’s network into 36 Mexican domestic markets and increased Delta’s US-Mexico profit margins by nine points. The next steps are to improve schedule connections, launch joint corporate contracts and start maintenance work at a joint-venture MRO facility in Mexico. The airlines disclosed back in 2012 that they had invested $50m to build the facility, which Delta said would “usher in lower maintenance costs” without compromising quality.
The Gol investment was an important strategic move, helping ensure that Delta has a partner in Latin America’s largest domestic market. Delta has gained exposure to 24 additional markets and improved its profitability in Brazil by 19%. Delta and Gol are looking to expand their codesharing and selling of joint corporate contracts and to “capitalise on co-location opportunities”.
Delta describes the Virgin Atlantic deal as a “unique opportunity to build network scale in the top US-Europe travels markets”. Heathrow is the world’s top business destination; of the ten largest transatlantic corporate markets, eight are to/from LHR. New York-LHR is the world’s most important business market.~Combining Virgin’s LHR slots and UK brand strength with Delta’s powerful US network should create an effective North Atlantic competitor to BA/American; together Delta and Virgin will represent about 25% of the LHR-US seats.
The benefits have been immediate: in the five months of so since the July 2013 start of codesharing, Delta collected $25m in incremental revenues and saw 0.5 points of increased market share. As cooperation is developed under the immunised JV, Delta expects the venture to produce $120m annual run-rate benefits.
The first coordinated schedule, effective this April, will see nine daily LHR-New York flights (of which two are to EWR), 24 LHR-US flights and 33 transatlantic flights. Delta will launch new service from Seattle and Detroit to LHR. The airlines have co-located at JFK and LHR for key markets. They will have joint corporate and agency sales programmes and expect cost savings from more efficient ground handling, maintenance and cargo operations.
Delta is counting heavily on the Virgin Atlantic JV for future revenue growth. In response to a question in the 4Q earnings call in January, the executives said that there had been a significant surge in interest from corporate customers, particularly from the banking community in New York, since the Virgin deal. “We now have a competitive shuttle product between JFK and LHR”, they noted.
Win in New York
In recent years Delta has invested heavily in the New York area airports. In 2012 Delta had an opportunity to expand significantly at LGA, following an earlier slot swap with US Airways. The deal involved Delta taking over most of US Airways’ Terminal C and gaining 132 daily slot pairs. Delta has spent $100m-plus to renovate and create an expanded two-terminal facility at the airport. All of that has enabled Delta to double its destinations from LGA and create the first true connecting hub there, with 260-plus daily departures to 60 cities.
At JFK, after long been handicapped by an ageing terminal (T3), Delta is benefiting from a new state-of-the-art facility (T4) that opened in May 2013. That first phase of a five-year $1.4bn project gave Delta nine new and seven renovated international gates and top-notch facilities.
The New York investments are beginning to pay off. Delta believes that its market share gap (passengers versus seats offered) has closed by 50%. LGA operations turned profitable in 2013. In the fourth quarter, the New York market led Delta’s domestic unit revenue improvement with an 8% increase, while Atlantic RASM out of New York was up by 7%. LGA had a spectacular 15% RASM gain.
But work remains to be done to fully close the market share gap in New York and to achieve profitability at JFK. Delta is determined to accomplish the latter in 2014 with the help of the Virgin JV, corporate share gains (particularly in the banking and financial services sectors), improved products and facilities, 50-seater retirements and the Gol and Aeromexico partnerships.
Selective network expansion
While Delta’s overall capacity growth will remain very modest (0-2% in 2014), there are pockets of opportunity, especially in Latin America, which currently accounts for only 9% of Delta’s capacity. The main growth areas will be Brazil, Mexico and the Caribbean. The Gol and Aeromexico partnerships will be important for maximising Delta’s reach in that region.
Delta’s efforts also focus on improving its positioning and profitability in Asia, which accounts for 12% of its total capacity. The airline has revised its thinking in light of the yen’s depreciation (which led to a $250m revenue hit in 2013), the liberalisation of Haneda and increased market demand for nonstop service to Asia. New strategies include reducing reliance on the Tokyo Narita hub, building Seattle as a key Asia gateway, developing new Pacific service also from other West Coast and mid-continent hubs and building relationships with leading carriers in the region (including China Eastern, China Southern, Korean and Virgin Australia).
Making Trainer refinery profitable
Two years ago Delta found a possible solution to reducing and limiting volatility in fuel prices: acquiring its own oil refinery. The airline predicted at that time that the Trainer facility in Pennsylvania would become profitable almost immediately and save it $300m-plus annually on fuel expenses.
As it turned out, profitability at Trainer has been elusive; the facility incurred a $116m loss in 2013. But Trainer has lowered jet fuel market prices, reducing Delta’s total fuel costs. Delta says that there are now initiatives in place to bring Trainer to modest profitability in 2014.
Are the improvements sustainable?
Delta is blazing the trail for the US legacies to become, in its management’s words, like any other “high-quality S&P 500 enterprise with consistent earnings, double-digit returns on capital and strong free cash flow”. In a few years, it is likely to become the second US airline (after Southwest) to enjoy investment-grade credit ratings.
Of course, while significantly behind, UAL and AAL are also heading in the same direction. At some point they can be expected to start growing their earnings at a faster rate than Delta, and it will only be a matter of time before they catch up.
By Heini Nuutinen